61st ANNUAL TULANE TAX INSTITUTE Looney- Changing Form... · 61st ANNUAL TULANE TAX INSTITUTE...
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61st ANNUAL TULANE TAX INSTITUTE Tulane University Law School NOVEMBER 1, 2012 NEW ORLEANS CHANGING FROM ONE FORM OF ENTITY TO ANOTHER: TAX CONSEQUENCES AND PITFALLS STEPHEN R. LOONEY DEAN, MEAD, EGERTON, BLOODWORTH, CAPOUANO & BOZARTH, P.A. 800 N Magnolia Avenue, Suite 1500 Orlando, FL 32803 407-428-5128 [email protected]
Transcript of 61st ANNUAL TULANE TAX INSTITUTE Looney- Changing Form... · 61st ANNUAL TULANE TAX INSTITUTE...
61st ANNUAL TULANE TAX INSTITUTE Tulane University Law School
NOVEMBER 1, 2012 NEW ORLEANS
CHANGING FROM ONE FORM OF ENTITY TO ANOTHER:
TAX CONSEQUENCES AND PITFALLS
STEPHEN R. LOONEY
DEAN, MEAD, EGERTON, BLOODWORTH,
CAPOUANO & BOZARTH, P.A.
800 N Magnolia Avenue, Suite 1500
Orlando, FL 32803
407-428-5128
Table of Contents
Page
i
I. INTRODUCTION .......................................................................................................................1
II. CHECK-THE-BOX REGULATIONS ......................................................................................2
A. In General ...............................................................................................................................2
B. Single Member “Eligible Entity” ...........................................................................................2
C. Multiple Member Entities ......................................................................................................2
D. Foreign Entities ......................................................................................................................2
E. Special Rules for Banks..........................................................................................................2
F. Validity of the CTB Regulations. ...........................................................................................2
G. Entity Classification Election.................................................................................................5
H. Effective Date ........................................................................................................................5
I. Extensions of Time to File an Election ...................................................................................5
J. Waiting Period .........................................................................................................................6
III. CHANGE OF A SOLE PROPRIETORSHIP OR DISREGARDED ENTITY INTO AN
ASSOCIATION TAXABLE AS A CORPORATION ....................................................................7
A. In General ...............................................................................................................................7
B. Tax Consequences to the Individual Owner of the Sole Proprietorship or Disregarded
Entity. ...........................................................................................................................................7
C. Tax Consequences to the Corporation. ................................................................................10
D. Other Considerations............................................................................................................10
IV. CHANGING A PARTNERSHIP INTO A CORPORATION ...............................................11
A. Incorporation of a Partnership ..............................................................................................11
B. “Assets Over” Transaction ...................................................................................................11
C. “Assets Up” Approach .........................................................................................................13
D. “Interests Over” Approach ...................................................................................................16
E. Incorporation of Partnership Under the Check-the-Box Regulations ..................................17
F. Conversion of a Partnership to a Corporation Under Applicable State Law Formless
Conversion Statute .....................................................................................................................17
G. Merger of Partnership into a Corporation Under Applicable State Law Cross-Entity
Merger Statute ............................................................................................................................18
V. CHANGING A CORPORATION INTO A SOLE PROPRIETORSHIP OR A
DISREGARDED ENTITY (SINGLE-MEMBER LIMITED LIABILITY COMPANY) ............18
A. In General .............................................................................................................................18
B. Tax Consequences to the Corporation. ................................................................................19
C. Tax Consequences to the Shareholder. ................................................................................20
VI. CHANGING A CORPORATION INTO A PARTNERSHIP ...............................................20
A. In General .............................................................................................................................20
B. “Assets Up” Approach for De-Incorporation Transactions .................................................21
C. “Assets Over” Approach for De-Incorporation Transaction ................................................23
D. “Interests Over” Approach ...................................................................................................25
E. Check-the-Box Regulations..................................................................................................27
F. State Law Formless Conversion Statute ...............................................................................27
G. Cross-Entity Merger Statute.................................................................................................27
VII. CONVERSIONS OF A DISREGARDED ENTITY INTO A PARTNERSHIP AND A
PARTNERSHIP INTO A DISREGARDED ENTITY..................................................................27
A. In General .............................................................................................................................27
Table of Contents
(continued)
Page
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B. Conversion of a Disregarded Entity into a Partnership: Increase From One Member to
Two (or More) Members ...........................................................................................................28
C. Conversion of a Partnership into A Disregarded Entity: Purchase of All of the Interests in
an LLC Taxable as a Partnership by One Buyer. .......................................................................28
VIII. CONVERSION OF A C CORPORATION INTO AN S CORPORATION .......................29
A. The Built-In Gain Tax Hurdle and Other Pitfalls of Conversion .........................................29
B. General Built-In Gain Tax Rules. ........................................................................................30
C. NUBIG Limitation. ..............................................................................................................31
D. Taxable-Income Limitation..................................................................................................32
E. Built-In Income and Built-In Deduction Items. ...................................................................32
F. Effect of Classification of Item as Built-in Income or Built-In Deduction Item. .................36
G. Section 481 Adjustments, Deemed DISC Distributions, COD Income and Income from
Completed Contract Method of Accounting. .............................................................................38
H. Installment Sales. .................................................................................................................39
I. Interests in Partnerships. ........................................................................................................40
J. Inventory Items......................................................................................................................42
K. After-Acquired Assets..........................................................................................................43
L. Anti-Stuffing Rule ................................................................................................................44
M. Pre-Conversion Planning Opportunities. .............................................................................44
N. Post Conversion Planning Opportunities .............................................................................56
IX. CHANGES IN FORM OF ENTITY NOT RESULTING IN CHANGE OF TAX STATUS
OF ENTITY ...................................................................................................................................59
A. In General .............................................................................................................................59
B. F Reorganizations .................................................................................................................59
X. CONCLUSION ........................................................................................................................64
CHANGING FROM ONE FORM OF ENTITY TO ANOTHER:
TAX CONSEQUENCES AND PITFALLS
Stephen R. Looney
I. INTRODUCTION
Over the last decade, nearly all states have enacted statutes that allow business entities to
convert from one type of entity to another type of entity by merely filing a form (such as
articles of conversion) with the state (state law formless conversion statutes).
Additionally, during this same time, many states have also enacted statutes allowing one
type of business entity to merge into a different type of business entity, such as the
merger of a corporation into an LLC (state law cross-entity merger statutes). The effect
of such statutes is that title to the assets of the entities is automatically owned by the
converted or surviving entity, and correspondingly liabilities are automatically owned by
the converted or surviving entity.
Additionally, since the issuance of the “check-the-box” regulations in 1997, eligible
entities have been able to select their classification for federal income tax purposes.
These state law formless conversion statutes, cross-entity merger statutes and the check-
the-box regulations can have significant non-tax and state tax law advantages, including:
1. the possible avoidance of non-transferability, acceleration and similar clauses
contained in various contracts;
2. avoiding application of transfer fees, sales taxes, documentary stamp taxes, etc.;
and
3. simplicity.
However, the ease of converting an entity from one type of entity to another type under
state law formless conversion statutes, state law cross-entity merger statutes and the
check-the-box regulations can present significant tax pitfalls and a trap for the unwary as
a result of the federal tax consequences resulting from changing the tax classification of
the entity for federal income tax purposes.
This outline will examine the tax consequences of changing from one form of entity to
another form of entity under the various methods available, including conversions of sole
proprietorships into corporations, the incorporation of a partnership, the conversion of a
corporation into a sole proprietorship or a single-member LLC that is a disregarded
entity, the conversion of a corporation into a partnership, the conversion of a disregarded
entity into a partnership, the conversion of a partnership into a disregarded entity and the
conversion of a C corporation into an S corporation. In addition to highlighting the tax
consequences of each of these transactions, the pitfalls associated with such transactions
will also be discussed.
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II. CHECK-THE-BOX REGULATIONS
A. In General. The check-the-box (“CTB”) regulations provide that an “eligible
entity” having two or more members is permitted to elect to be classified as an
“association” taxable as a corporation, or, alternatively, report its tax items as a
partnership. Treas. Reg. § 301.7701-3(a). The default rule, i.e., non-election, is
that of a partnership for federal income tax purposes.
B. Single Member “Eligible Entity”. Where an eligible entity has only a single
owner or member, it may elect to be classified as an association taxable as a
corporation or be disregarded as an entity (a so-called “disregarded entity” or
“DE”) for federal tax purposes. Treas. Reg. § 301.7701-3(b)(1). Under the
default rule, a single member eligible entity will be treated as a DE.
C. Multiple Member Entities. Unless a “per se” corporation, including a foreign
“per se” corporation under the CTB regulations, a multiple member entity may be
classified as a partnership unless it elects to file a reverse election to be treated as
a corporation. Under the default rule, a multi-member entity will be treated as a
partnership under Subchapter K unless it files an election to be classified as an
“association” taxable as a corporation.
D. Foreign Entities. Certain foreign corporations or entities are required by specific
list under the regulations to be treated as “per se” corporations. Treas. Reg.
§ 301.7701-2(b)(8)(i). However, for foreign entities which fall outside the scope
of the “per se” rule, the CTB regulations provide default rules for entity
classification. Unless an entity elects otherwise, (1) a multi-member foreign
entity will be classified as an association if all members have limited liability, or
a partnership if one or more members does not have limited liability, and (2) a
single-member entity will be classified as an association if the member has
limited liability, or as a disregarded entity if the member does not. Treas. Reg.
§ 301.7701-3(b)(2).
E. Special Rules for Banks. A domestic or foreign bank cannot treat a wholly
owned nonbank entity as a DE for purposes of applying the special provisions in
the Code applicable to banks. Treas. Reg. § 301.7701-2(c)(2)(ii).
F. Validity of the CTB Regulations.
1. McNamee v. Comm’r. In McNamee v. Comm’r, 488 F.3d 100 (2d Cir.
2007), the Second Circuit Court of Appeals upheld the validity of the CTB
regulations and affirmed a collection due process (“CDP”) determination
that an individual owner was personally liable for unpaid payroll taxes of
an accounting firm/single member LLC that had not elected to be treated
as a corporation. The CTB regulations were found to be a reasonable
interpretation of somewhat ambiguous language contained in section 7701
and provided a reasonable approach in allowing a single member eligible
entity to elect between an association or DE. The fact that the IRS had
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proposed regulation changes that would definitively treat the entity as
compared to the single member owner as the employer for payroll tax
purposes was irrelevant and didn’t change the reasonableness of existing
regulations since the changes were only proposed.
2. Littriello v. United States, 484 F.3d 372 (6th Cir. 2007), cert. denied, 28
S. Ct. 1290 (Feb. 19, 2008). A district court decision upholding the
validity of the “check-the-box” regulations, and the sole owner-sole
member’s personal liability, as sole proprietor for employment taxes of
LLCs that had not elected to be treated as a corporation, was affirmed by
the Sixth Circuit Court of Appeals. The court found the regulations to be
a reasonable interpretation of what was ambiguity in Section 7701 as
applied to hybrid entities; so, taxpayer’s failure to elect corporation
treatment for LLCs clearly resulted under regulations in LLCs being
disregarded and deemed sole proprietorships for tax purposes. The
taxpayer’s argument that the statute was clear, and that it was the
regulations that brought in ambiguity, was illogical and contrary to
established Supreme Court law. This ambiguity was exacerbated by the
different state law treatments of single member entities. Similarly, the
argument that the IRS was required to recognize an LLCs’ separate
existence as a matter of state law was flawed and based on distinguishable
case precedent. Additionally, the taxpayer’s attempt to apply proposed
amendments, providing that single-owner eligible entities be treated as
separate entities for employment tax purposes, was rejected. The court
found the regulations were a reasonable interpretation of what was an
ambiguity under Section 7701 because Sections 7701(a)(2) and 7701(a)(3)
fail to make a clear distinction between an “association” treated as a
corporation and a “group, pool or joint venture,” which is treated as a
partnership. The taxpayer’s failure to elect corporation treatment for
LLCs resulted in DE status and treatment as sole proprietorships for tax
purposes.
3. Eligible Entities. An eligible entity is an entity which is neither a trust
under Treas. Reg. § 301.7701-4, nor a “corporation” under Treas. Reg. §
301.7701-2(b). See Treas. Reg. §§ 301.7701-2(a), 301.7701-3(a).
a. Per Se Corporation. A corporation as defined in Treas. Reg. §
301.7701-2(b) is always classified as a corporation for federal tax
purposes. A corporation includes (i) a business entity organized
under federal or state law that describes the entity as a body
corporate, joint stock company or joint stock association; (ii) an
insurance company or state chartered bank (Treas. Reg.
§§ 301.7701-2(b)(4), 301.7701-2(b)(5)); (iii) a business entity
wholly owned by a state or political subdivision thereof or a
foreign government (Treas. Reg. § 301.7701-2(b)(6)); (iv) a
business entity taxable as a corporation (see Treas. Reg.
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§ 301.7701-2(b)(7)); and (v) a foreign entity required to be treated
as a corporation under Treas. Reg. § 301.7701-2(b)(8).
b. Dual-Chartered Entities. The regulations provide that if the entity
would be treated as a corporation as a result of its formation in any
of the jurisdictions in which it is organized, then it is treated for
federal tax purposes as a corporation even though its organization
in the other jurisdictions would not have caused it to be treated as a
corporation. Treas. Reg. § 301.7701-2. A dual chartered entity
will be treated as domestic if organized as any form of entity in the
U.S. regardless of how it is organized in any foreign country.
Treas. Reg. § 301.7701-5. For grandfather provisions in the
regulations, see Treas. Reg. § 301.7701-2(e)(3)(ii). Also see
Treas. Reg. § 301.7701-2(b)(9), Example (1).
(1) Facts. X is an entity with a single owner organized under
the laws of Country A as an entity that is listed in
paragraph (b)(8)(i) of this section. Under the rules of this
section, such an entity is a corporation for Federal tax
purposes and under Treas. Reg. § 301.7701-3(a) is unable
to elect its classification. Several years after its formation,
X files a certificate of domestication in State B as a limited
liability company (LLC). Under the laws of State B, X is
considered to be created or organized in State B as an LLC
upon the filing of the certificate of domestication and is
therefore subject to the laws of State B. Under the rules of
this section and Treas. Reg. § 301.7701-3, an LLC with a
single owner organized only in State B is disregarded as an
entity separate from its owner for Federal tax purposes
(absent an election to be treated as an association). Neither
Country A nor State B law requires X to terminate its
charter in Country A as a result of the domestication, and in
fact X does not terminate its Country A charter.
Consequently, X is now organized in more than one
jurisdiction.
(2) Result. X remains organized under the laws of Country A
as an entity that is listed in paragraph (b)(8)(i) of this
section, and as such, it is an entity that is treated as a
corporation under the rules of this section. Therefore, X is
a corporation for Federal tax purposes because the rules of
this section would treat X as a corporation with reference to
one of the jurisdictions in which it is created or organized.
Because X is organized in Country A in a manner that does
not meet the definition of an eligible entity in Treas. Reg.
§ 301.7701-3(a), it is unable to elect its classification.
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c. Special Rule for Cross Border Subsidiaries. A domestic
corporation may elect to have a wholly owned Canadian or
Mexican subsidiary treated as a domestic corporation for all U.S.
income tax purposes if the subsidiary is organized and “maintained
solely for the purpose of complying with the laws of [Canada or
Mexico] as to the title and operation of property.” Section
1504(d). See Notice 2000-7, 2000-4 IRB 419 (effect of repeal of
certain Canadian banking legislation on section 1504(d) elections).
G. Entity Classification Election. An “eligible entity” is required to make an entity
classification election by filing Form 8832, Entity Classification Election. Treas.
Reg. § 301.7701-3(c)(1)(ii).
H. Effective Date. The election will be effective on the date specified by the entity
on Form 8832, or on the date filed if no date is specified on the election form.
Treas. Reg. § 301.7701-3(c)(1)(iii). The specified effective date cannot be more
than 75 days prior to or 12 months after the date on which the election was filed.
Treas. Reg. § 301.7701-3(c)(1)(iii).
I. Extensions of Time to File an Election. Under Treas. Reg. § 301.9100, the IRS
has authority to grant an extension of time to make an election. Typically, an
entity must apply for a waiver for a late election by making a private letter ruling
request (for which a user fee must be paid) to the IRS. In response to the deluge
of letter rulings requesting approval for late elections, the IRS issued Rev. Proc.
2002-15, 2002-1 C.B. 490. This revenue procedure provided a simplified method
for newly formed entities to request relief for the late filing of their initial
classification election by permitting an initial “election out” of the default
classification rules in Treas. Reg. §§ 301.7701-3(b)(1) and 301.7701-3(b)(2) to be
made by filing Form 8832 within six months and 75 days of the entity’s
formation. An entity is eligible for relief if three conditions are met: (1) the entity
failed to obtain its desired classification as of the date of its formation because
Form 8832 was not timely filed; (2) the due date for the entity’s initial tax return
has not passed; and (3) the entity had “reasonable cause” for its failure to make a
timely election.
1. Extended Time to File. Subsequently, the IRS has extended the time for
requesting relief from the six months (and 75 days) permitted under Rev.
Proc. 2002-15, to the unextended due date of the entity’s federal tax return
for the year of the entity’s formation in Rev. Proc. 2002-59, 2002-2 C.B.
615. More recently, in Rev. Proc. 2009-41, 2009-39 I.R.B. 439, the IRS
extended late entity classification relief to both initial classification
elections and changes in classification elections along with extending the
time for filing late entity classification elections to within 3 years and 75
days of the requested effective date of the eligible entity’s classification.
Additionally, Rev. Proc. 2009-41 provides guidance for those eligible
entities that do not qualify for relief under this revenue procedure and that
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are required to request a letter ruling in order to request relief for a late
entity classification election.
2. S Corporations. The IRS has provided a safety net of relief for untimely
filed S corporation elections in a variety of situations. With respect to
entity classification elections, if an entity files an S corporation election
but fails to file Form 8832, the entity will be deemed to have filed an
election to be treated as a corporation under Treas. Reg. § 301.7701-
3(c)(1)(v)(C).
In addition, if an entity fails to timely file an S corporation election (see
generally Section 1362(b)(1)), the IRS has provided a simplified, special
procedure to request relief for the late filing of both elections. See Rev.
Proc. 2004-48, 2004-2 C.B. 172; and Rev. Proc. 2007-62, 2007-41 I.R.B.
786 (supplementing Rev. Proc. 2004-48 and providing an additional
simplified method for certain eligible entities to request relief for late S
corporation elections and late entity classification elections).
J. Waiting Period. Under the check-the-box regulations, an eligible entity that
elects to change its classification cannot elect to change its classification again
during the 60 months succeeding the effective date of the prior election (the “60-
month waiting period”). Treas. Reg. § 301.7701-3(c)(1)(iv). The 60-month
waiting period, however, does not apply to an eligible entity that elects out of its
default classification effective from its inception. See Treas. Reg. § 301.7701-
3(c)(1)(iv).
1. Rescission of Election. Additionally, an entity may rescind an entity
classification election without triggering the 60-month waiting period
provided such a rescission occurs before the end of the same taxable year
as the initial conversion. See PLR 200952036 (Dec. 24, 2009) (permitting
a C corporation, which was previously a limited partnership, to rescind
incorporation, convert into an LLC, and maintain partnership treatment for
federal income tax purposes at all times during the tax year in question);
PLR 200843001 (July 2, 2008) (permitting rescission of the sale of a
portion of a foreign DE’s ownership interests to avoid triggering an
automatic classification change to a partnership); PLR 200613027 (Dec.
16, 2005) (permitting rescission of the conversion of an LLC taxable as a
partnership to a C corporation in anticipation of a failed initial public
offering).
2. IRS Reconsidering Availability of Rescissions. In Rev. Proc. 2012-3,
2012-1 I.R.B. 113, the IRS added as a no rule area, whether a completed
transaction can be rescinded for federal income tax purposes. This issue is
identified as an area under study in which rulings will not be issued until
the IRS resolves the issue through publication of a revenue ruling, a
revenue procedure, regulations or other guidance.
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III. CHANGE OF A SOLE PROPRIETORSHIP OR DISREGARDED ENTITY INTO
AN ASSOCIATION TAXABLE AS A CORPORATION
A. In General. One of the simplest types of changes in entity status is the
incorporation of a sole proprietorship. This may be achieved by actual
incorporation of a sole partnership, the filing of a Form 8832, Entity
Classification Election, for a disregarded entity (such as a single-member LLC) to
be treated as an association taxable as a corporation, the conversion of a single-
member LLC treated as a DE into a corporation under the applicable state law
formless conversion statute, or the merger of a single-member LLC treated as a
DE into a corporation under the applicable state law cross-entity merger statute.
Whether achieved by actual incorporation of the sole proprietorship, filing an
election under Section 8832 for a single member LLC to be taxed as an
association, the conversion of a single-member LLC into a corporation under the
applicable state law formless conversion statute or the merger of a single-member
LLC treated as a DE into a corporation under the applicable state law cross-entity
merger statute, the tax consequences to the individual and the corporation should
be the same.
B. Tax Consequences to the Individual Owner of the Sole Proprietorship or
Disregarded Entity.
1. Recognition of Gain or Loss. Under the general rule of Section 351(a),
no gain or loss is recognized if property is transferred to a corporation by
one or more persons solely in exchange for stock in such corporation and
immediately after the exchange such person or persons are in control of
the corporation.
a. The general non-recognition rules of Section 351 will not apply if
the new corporation constitutes an “investment company” under
Section 351(e).
b. A corporation may be classified as an “investment company” if
more than 80% of its assets are held for investment and constitutes
stock, securities, money, etc. Sections 351(e)(1)(A) and (B), and
Treas. Reg. §§ 1.351-1(c)(1)(ii), (iii) and (iv).
c. Even if the 80% test is met, the company will not be classified as
an “investment company” unless it results in “diversification.”
Diversification does not occur if each of the transferors conveys
identical assets to the newly organized corporation. Additionally,
diversification does not occur if not more than 25% of the portfolio
of stock and securities conveyed by each transferor constitutes
stock and securities of any one issuer, and not more than 50% of
such portfolio is in the stock and/or securities of five or fewer
issuers. Section 368(a)(2)(F)(i) and Treas. Reg. §§ 1.351-1(c)
(1)(ii)(5), (6) and (7).
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2. Receipt of Boot. If any cash or “other property” is received in connection
with an incorporation, the transaction will not be disqualified from non-
recognition treatment under Section 351(a), however, gain (the excess, if
any, of the fair market value of the stock and other consideration received
over the basis of the transferred assets) realized in the transaction will be
recognized to the extent of any such cash or “other property” (i.e., “boot”)
received. Specifically, Section 351(b) provides that if Section 351(a)
would apply to an exchange but for the fact that there is received, in
addition to the stock permitted to be received under Section 351(a), other
property or money, then gain to such recipient will be recognized but not
in excess of the amount of money received, plus the fair market value of
such other property received. Section 351(b)(2) provides that if a
transferor receives boot, no loss may be recognized by the recipient.
a. Rev. Rul. 68-55, 1968-1, C.B. 140, provides that in determining
gain recognized under Section 351(b)(1), where several assets are
transferred, each asset must be considered transferred separately in
exchange for a portion of each category of consideration received.
Each category of consideration received by the transferor is
separately allocated to the transferred assets in proportion to their
relative fair market values.
b. If a loss is realized with respect to any particular asset, it will not
be recognized under Section 351(b)(2).
3. Property Requirement. Section 351(d) provides that for purposes of
Section 351, stock issued for: (1) services, (2) indebtedness of the
transferee corporation which is not evidenced by a security; or (3) interest
on indebtedness of the transferee corporation which is accrued on or after
the beginning of the transferor’s holding period for the debt, is not
considered as issued in return for property. Under such circumstances,
ordinary income could be realized to the extent that any stock received in
the transaction is not attributable to the contribution of “property.”
4. Liabilities.
a. General Rules. Under the general rule of Section 357(a), if the
taxpayer receives property which is permitted to be received under
Section 351 without the recognition of gain if it were the sole
consideration, and as part of the consideration, another party to the
exchange assumes the liability of the taxpayer, then such
assumption will not be treated as money or other property, and will
not result in the recognition of gain except as provided below.
b. Liabilities in Excess of Basis. Under Section 357(c), to the extent
that the aggregate amount of liabilities assumed by the corporation
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(or assets to which the assets received by the corporation in the
transaction are subject) exceeds the adjusted basis of the assets
transferred to the corporation, gain is recognized.
c. “Nasty Purpose Liabilities.” Under Section 357(b), if, taking into
consideration the nature of the liability and the circumstances in
light of which the arrangement for the assumption was made, it
appears that the principal purpose of the taxpayer with respect to
the assumption of the liability was to avoid federal income tax on
the exchange, or was not a bona fide business purpose, then such
assumption (in the total amount of the liability assumed pursuant to
the exchange) will, for purposes of Section 351, be considered as
money received by the taxpayer on the exchange.
5. Control. Another requirement that must be met for the nonrecognition
rules of Section 351 to apply is that the transferors of the property to the
corporation must be in “control” after the transaction. Section 368(c)
defines the term “control” to mean the ownership of stock possessing at
least 80% of the total combined voting power of all classes of stock
entitled to vote and at least 80% of the total number of shares of all other
classes of stock of the corporation. An example of where this test would
not be met is where even though the sole proprietor or individual owner of
the disregarded entity receives the requisite ownership “immediately after
the exchange,” there is a plan to transfer stock to non-transferors as part of
the same transaction. Three tests are primarily used to determine whether
the transferors have control of the corporation “immediately after the
exchange”:
a. Binding Commitment Test. The binding commitment test is
relatively straight forward. If, at the time the parties commence
the first transaction, they are under a binding commitment to
undertake the subsequent transactions, then all transactions will be
integrated into one transaction.
b. Mutual Interdependence Test. This test has been articulated as
being the question of whether “the steps were so interdependent
that the legal relations created by one transaction would have been
fruitless without a completion of the series.”
c. End Results Test. Under the end results test, the IRS looks to
whether the parties intended in the beginning to achieve a
particular result, and whether the separate steps were merely
entered into as a means of achieving that result.
6. Basis for Stock. Under Section 358(a)(1), in the case of an exchange to
which Section 351 applies, the basis of the stock received by the transferor
is the same as the basis of the property exchanged: (a) decreased by the
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fair market value of any other property and money received by the
taxpayer; (b) decreased by the amount of loss to the taxpayer which was
recognized on the exchange; and (c) increased by the amount of gain to
the taxpayer which was recognized on such exchange (a “substituted
basis”).
7. Holding Period for Stock. The holding period for the stock received in
the exchange will receive “tacking” of the holding period of any assets
transferred to the corporation, provided, however, ordinary income assets
(assets other than a capital asset as defined in Section 1221 or property
described in Section 1231) are not entitled to tacking and the holding
period for the stock begins on the date following the date of the exchange.
Section 1223(1).
C. Tax Consequences to the Corporation.
1. Nonrecognition of Gain or Loss. Under Section 1032(a), no gain or loss
is recognized to a corporation on the receipt of money or other property in
exchange for stock of such corporation.
2. Basis of Property Contributed to Corporation. Under Section
362(a)(1), the basis of property contributed to a corporation in a
transaction to which Section 351 applies is equal to the basis of the assets
in the hands of the transferor, increased by the amount of gain recognized
to the transferor on such transfer (a “carryover” or “transferred” basis).
3. Holding Period of Property Contributed to Corporation. Since the
assets will have a “carryover” or “transferred” basis to the transferee
corporation, Section 1223(2) allows the transferee corporation to tack on
the transferor’s holding period for the contributed assets.
D. Other Considerations.
1. Employer Identification Number. In the case of the incorporation of a
sole proprietorship, a new employer identification number will need to be
obtained for the corporation. In the case of an election by a disregarded
entity such as a single-member LLC to be treated as an association taxable
as a corporation, the conversion of a disregarded entity into a corporation
under the applicable state law formless conversion statute, or the merger
of a disregarded entity into a corporation under the applicable state law
cross-entity merger statute, if the disregarded entity had an employer
identification number prior to the transaction, then the corporation would
use that number; otherwise, the corporation must obtain a new employer
identification number.
2. S Election. Regardless of whether the transaction involves the
incorporation of a sole proprietorship, the election by a disregarded entity
under the check-the-box regulations to be treated as an association taxable
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as a corporation, the conversion of a disregarded entity such as a single-
member LLC under the applicable state law formless conversion statute,
or the merger of a disregarded entity into a corporation under the
applicable state law cross-entity merger statute, if the corporation desires
to be taxed as an S corporation, an S election will need to be filed for the
corporation within two months and fifteen days of the incorporation,
election to be treated as a corporation, conversion or merger, as the case
may be. Sections 1362(a) and (b).
IV. CHANGING A PARTNERSHIP INTO A CORPORATION
A. Incorporation of a Partnership. In Rev. Rul. 84-111, 1984-2 C.B. 88, the IRS
permitted taxpayers to choose their tax treatment in partnership incorporation
transactions by structuring the transaction in one of three ways. Each of the three
methods treats the incorporation as a two-step process.
B. “Assets Over” Transaction. The first method set forth in Rev. Rul. 84-111, is
the so-called “assets over” or “partnership asset transfer” approach. Under this
approach, the partnership first transfers its assets to the newly organized
corporation in exchange for the stock and the assumption by the corporation of
the liabilities of the partnership, and in the second step the partnership liquidates
by distributing the corporate stock received in the incorporation transaction to the
partners in accordance with their partnership interests.
1. Tax Consequences to Partnership on First Step of Transaction:
Transfer of Assets by the Partnership to the Corporation.
a. Under Section 351, generally no gain or loss will be recognized by
the partnership on the transfer of all of its assets to the corporation
for the corporation’s stock and the assumption by the corporation
of the partnership’s liabilities.
b. Under Section 358(a), the basis to the partnership of the stock
received from the corporation is the same as the basis to the
partnership of the assets transferred to the corporation, reduced by
the liabilities assumed by the corporation, which assumption is
treated as the payment of money to the partnership under Section
358(d). Additionally, the assumption by the corporation of the
partnership’s liabilities decreases each partner’s share of the
partnership liabilities, and as such, decreases the basis of each
partner’s partnership interest under Sections 752 and 733.
c. Under Section 1223(1) of the Code, the partnership’s holding
period for the stock received in the exchange includes its holding
period in the capital assets and Section 1231 assets transferred to
the corporation (to the extent that the stock is received in exchange
for such assets). To the extent that stock was received in exchange
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for non-capital/non-1231 assets, the partnership’s holding period
for such stock begins on the date following the date of the
exchange. See Rev. Rul. 70-598, 1970-2 C.B. 168.
2. Tax Consequences to Corporation on First Step of Transaction.
a. Under Section 1032, the corporation recognizes no gain or loss on
the issuance of its stock to the partnership in exchange for the
partnership’s assets.
b. Under Section 362(a), the corporation’s basis in the assets received
from the partnership generally equals their basis to the partnership
immediately before the transfer (i.e., a carryover basis). If the
partnership had a lower basis in its assets than the partners have in
their partnership interests, this could result in the corporation
receiving a lower basis than it would have had if the partners
transferred their partnership interests to the corporation in an
“interests over” transaction discussed below. However, the
corporation should receive the benefit of any prior step-ups in basis
attributable to a sale, exchange or distribution transaction to which
a Section 754 election previously applied.
c. Because the corporation will generally receive a carryover basis in
the assets of the partnership, the corporation will continue to
depreciate such carryover basis in the same manner as the assets
were previously being depreciated by the partnership. However,
any increase of basis resulting from the various gain recognition
rules discussed above would be subject to the depreciation period,
method and convention applicable to a newly acquired asset.
d. Under Section 1223(2), the corporation’s holding period in the
assets transferred to it will include the partnership’s holding period
in such assets.
3. Tax Consequences to Partners on Second Step of Transaction:
Distribution of Stock in Liquidation of Partnership.
a. Under Section 731(a), no gain or loss will be recognized by the
partners upon the distribution of the stock of the corporation to the
partners in complete liquidation of the partnership.
b. Under Section 732(b), the adjusted bases of the former partners in
their stock of the new corporation will be the same as the adjusted
bases in their interests in the partnership (as increased by any gain
resulting from the transfer of the partnership’s assets to the
corporation, and decreased by any liabilities transferred to the
corporation, in the first step of the transaction).
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c. As discussed in IV.B.1.c. above, the parties will receive a tacking
of holding period for the stock received to the extent the stock was
received in exchange for capital or Section 1231 assets.
4. Tax Consequences to Partnership on Second Step of Transaction.
a. Under Section 731(b), the partnership will recognize no gain or
loss on the distribution of the stock of the corporation to the
partners in complete liquidation of the partnership.
b. Under Section 708(b)(1)(A), the partnership will be terminated.
5. Other Tax Consequences.
a. Rev. Rul. 84-111 also provides that the momentary ownership by
the partnership of the corporation’s stock should not violate the
control requirement of Section 368(c) of the Code.
b. Additionally, the momentary ownership of the corporation’s stock
by the partnership will not preclude it from qualifying as an S
corporation so that it will not be subject to the built-in-gain tax.
See Section 1374(c)(1). Also see PLR 8926016 (March 29, 1989);
PLR 9421022 (Feb. 24, 1994); PLR 9422055 (March 10, 1994);
and Rev. Rul. 72-320, 1972-1 C.B. 270.
c. Finally, stock received in an “assets over” partnership
incorporation may not satisfy the original issuance requirement in
order to qualify for Section 1244 loss treatment, whereas stock
received under the “assets up” and “interests over” methods, which
will be discussed below, may qualify for Section 1244 loss
treatment.
C. “Assets Up” Approach. Under this approach, the partnership first liquidates by
distributing its assets, subject to its liabilities, to its partners. The second step is
the transfer by the partners of assets received from the partnership to the
transferee corporation in exchange for the stock of the corporation.
1. Tax Consequences to Partners on First Step of Transaction:
Liquidation of the Partnership.
a. Under Section 731(a), in general no gain or loss will be recognized
by the partners upon their complete liquidation of the partnership,
with certain exceptions. Under Sections 731(a)(1) and (c), gain is
recognized to the extent that a partner’s share of cash, and with
certain exceptions, marketable securities, distributed to him
exceeds his adjusted basis in the partnership. Additionally, a
partner may be required to recognize gain on the liquidation if he
contributed appreciated property to the partnership within the last 7
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years under Sections 704(c)(1)(D) and 737. However, these
provisions do not apply to the extent the partner receives back the
same property he originally contributed, or receives only a portion
of that property and no other property. Sections 704(c)(1)(B),
737(d), 751(b)(2)(A), and Treas. Reg. § 1.704-4(c)(2). The gain
recapture rules only apply to “assets up” transactions. Treas. Reg.
§§ 1.704-4(c)(4) and 1.737-2(c).
b. Under Section 732(b), the basis of the partners in the assets
deemed distributed in liquidation of the partnership will be based
upon the partners’ adjusted basis in their partnership interests,
rather than the partnership’s prior basis in the assets themselves.
Consequently, the “assets up” approach may produce a different
result than the “assets over” approach. Each partner’s basis in his
partnership interest will then be allocated separately among the
assets distributed by the partnership (and subsequently contributed
to the corporation by the partners) in the following manner:
(1) Each partner’s basis in his partnership interest is allocated
first to Section 751 property to the extent of the
partnership’s basis in the assets. To the extent the new
partner receives more or less than his proportionate share of
Section 751 property, there is a deemed sale.
(2) Any remaining basis of the partner in his partnership
interest is allocated among the partnership’s non-Section
751 property. If there is excess partner interest basis left
over after the allocation to Section 751 property and there
is no non-Section 751 property, the partner may be able to
recognize a capital loss. See Section 731(a)(2) and Treas.
Reg. § 1.732-1(c)(3).
(3) Any differences between the partner’s aggregate basis in
his partnership interest and the partnership’s aggregate
asset basis to which that partner’s partnership interest basis
is allocated is used first to reduce the disparities between
the fair market value and the adjusted basis of the
individual assets.
(4) Any excess remaining basis is allocated among all of the
partnership’s non-Section 751 property in proportion to fair
market value. If there is a deficiency in partner interest
basis at either the Section 751 property allocation step or
the non-Section 751 property step, the deficiency is
allocated in proportion to the partnership’s basis in the
relevant category of assets.
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c. Under Section 735(b), the partners’ holding periods for the assets
distributed to them by the partnership generally includes the
partnership’s holding period in such assets.
2. Tax Consequences to Partnership on First Step of transaction.
a. On the liquidating distribution of all of the partnership’s assets to
its partners, the partnership terminates under Section 708(b)(1)(A)
b. Under Section 731(b), the partnership recognizes no gain or loss
on the liquidating distribution of its assets to its partners.
3. Tax Consequences to Partners on Second Step of Transaction:
Transfer of Assets to the Corporation in Exchange for Stock.
a. Under Section 351, no gain or loss is recognized by the
partnership’s former partners on the issuance by the corporation of
its stock for the assets and liabilities of the partnership received by
the partnership’s partners in liquidation of the partnership.
b. Under Section 358(a)(1), the basis to the former partners of the
stock received from the corporation is the same as the Section
732(b) basis to the former partners in the assets received in
liquidation of the partnership (and transferred to the corporation),
reduced by the liabilities assumed by the corporation, which
assumption is treated as the payment of money to the partners
under Section 358(d).
c. Under Section 1223(1), the partners’ holding periods for the stock
received in the exchange includes the partners’ holding periods in
the capital assets and Section 1231 assets transferred to the
corporation (to the extent that the stock was received in exchange
for such assets). However, to the extent that the stock received
was in exchange for non-capital and non-1231 assets, the holding
period of the stock begins on the date following the date of the
exchange.
4. Tax Consequences to Corporation on Second Step of Transaction.
a. Under Section 1032, the corporation recognizes no gain or loss
upon the issuance of its stock in exchange for the assets
contributed to the corporation by the former partners of the
partnership which they received in liquidation of the partnership.
b. Under Section 362(a), the corporation’s basis in the assets received
from the former partners of the partnership equals the basis of the
former partners as determined under Section 732(b) and allocated
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among the assets under Section 732(c) immediately before the
transfer to the corporation.
c. Under Section 1223(2), the corporation’s holding period of the
assets received from the former partners of the partnership
generally includes the partners’ holding periods in such assets.
d. Again, to the extent the corporation receives a carryover basis in
the assets of the partnership, the corporation will continue to
depreciate such carryover basis in the same manner as the assets
were previously being depreciated by the partnership. However,
any increase of basis resulting from the various deemed
recognition rules would be subject to a new depreciation period,
method and convention applicable to a newly acquired asset.
D. “Interests Over” Approach. Under the third approach set forth in Rev. Rul. 84-
111, the partners first transfer their partnership interests to the transferee
corporation in exchange for the corporation’s stock, and in the second step the
partnership automatically dissolves because it has only one partner.
1. Tax Consequences to Partners on First Step of Transaction: Transfer
of Partnership Interests to Corporation in Exchange for Stock.
a. Under Section 351, generally no gain or loss should be recognized
by the partners on the transfer of their partnership interests to the
corporation in exchange for the corporation’s stock.
b. Under Section 358(a), the adjusted basis of the partners in the
stock of the corporation should be equal to the basis in their
partnership interests, reduced by any liabilities assumed.
c. Under Section 1223(1), the holding periods of the partners for the
stock received from the corporation will include the respective
holdings periods in their partnership interests, except that stock
received for Section 751 assets that are not capital/1231 assets will
have a new holding period.
2. Tax Consequences to Corporation on First Step of Transaction.
a. Under Section 1032, the corporation will recognize no gain or loss
on the issuance of its stock to the partners in exchange for their
partnership interests.
b. Under Section 362(a), the corporation’s basis in the partnership
interests received from the former partners of the partnership
should be equal to the former partners’ basis in their partnership
interests.
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c. Under Section 1223(2), the corporation’s holding period in the
partnership interests received from the former partners of the
partnership should generally include the partners’ holding periods
for their partnership interests.
3. Tax Consequences to Partnership on Second Step of Transaction:
Liquidation of the Partnership.
a. Under Section 708(b)(1)(A), the partnership will terminate since it
only has one partner.
b. Under Section 731(b), the partnership will recognize no gain or
loss on the distribution of its assets in liquidation to the
corporation.
4. Tax Consequences to Corporation on Second Step of Transaction.
a. Under Section 732(b), the corporation’s adjusted basis in the assets
it receives in the deemed liquidation of the partnership should be
equal to the corporation’s basis in the partnership interests, which
in turn is equal to the partners’ adjusted basis in their partnership
interests. However, the basis allocation rules under Section 732(c)
may produce different results in the “interests over” method than in
the “assets up” method, because there is only one partner upon
dissolution of the partnership.
b. Under Section 1223(2), the corporation’s holding period in the
assets includes the partnership’s holding period in the assets.
c. The corporation should continue to use the partnership’s
depreciation method, etc. on the carryover basis of any transferred
assets, and the corporation’s holding periods for such assets should
be the same as the partnership’s historical holding periods.
However, as discussed above, any increase in basis would have to
be recovered under a new depreciation method and period, and a
new holding period would begin for such assets.
E. Incorporation of Partnership Under the Check-the-Box Regulations. Under
Treas. Reg. § 301.7701-3(g)(1)(i), elections from partnership to corporation status
under the check-the-box regulations are treated as made under the “assets over”
approach.
F. Conversion of a Partnership to a Corporation Under Applicable State Law
Formless Conversion Statute. Rev. Rul. 2004-59, 2004-1 C.B. 1050, provides
that when a partnership is converted to a corporation under the applicable state
law formless conversion statute, the “assets over” approach applies.
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G. Merger of Partnership into a Corporation Under Applicable State Law
Cross-Entity Merger Statute. Presumably, the merger of a partnership into a
corporation under the applicable state law cross-entity merger statute will also be
treated as made under the “assets over” approach. See PLR 9409035 (Dec. 7,
1993).
V. CHANGING A CORPORATION INTO A SOLE PROPRIETORSHIP OR A
DISREGARDED ENTITY (SINGLE-MEMBER LIMITED LIABILITY
COMPANY)
A. In General. As opposed to an “incorporation” transaction such as the
incorporation or conversion of a sole proprietorship or partnership into a
corporation, the changing of a corporation or association taxed as a corporation
into a sole proprietorship (or a partnership as will be discussed below), constitutes
a “de-incorporation” transaction, which will result in a taxable liquidation of the
corporation. One of the simplest types of de-incorporation transactions, is the
changing of a corporation into a sole proprietorship or single-member LLC
treated as a disregarded entity for tax purposes.
1. As with the incorporation transactions discussed above, the change in
entity status can be achieved by the actual liquidation of the corporation or
an LLC which elected to be treated as an association taxable as a
corporation, the conversion of a corporation into a single-member LLC
(which does not elect to be treated as an association taxable as a
corporation) under the applicable state law formless conversion statute, the
merger of the existing corporation into a single-member LLC (which does
not elect to be treated as an association taxable as a corporation) under the
applicable state law merger statute, or for an eligible entity such as an
LLC which has previously elected to be treated as an association taxable
as a corporation, the filing of a Form 8832, Entity Classification Election,
to change the status of the entity from an association taxable as a
corporation to a disregarded entity.
2. Whether achieved by a simple liquidation of the corporation to the sole
shareholder who will operate the business as a sole proprietorship or form
a new single-member LLC to operate the business, the conversion of a
corporation into a single-member LLC under the applicable state law
formless conversion statute for which an election is not made to treat the
single-member LLC as an association taxable as a corporation, the merger
of a corporation into a single-member LLC under the applicable state law
merger statute where no election is made to treat the single-member LLC
as an association taxable as a corporation, or the filing of a Form 8832
election for a change in classification of an eligible entity such as a single-
member LLC which previously elected to be treated as an association
taxable as a corporation to be treated as a disregarded entity, the tax
consequences to the corporation and the shareholder should be the same.
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B. Tax Consequences to the Corporation.
1. Recognition of Gain or Loss. Under the general rule of Section 336, the
corporation will be treated as distributing all of its assets and liabilities to
its sole shareholder in complete liquidation of the corporation.
Specifically, Section 336(a) provides that the corporation will be treated as
if its property were sold to the distributee at its fair market value.
2. Treatment of C Corporation Versus S corporation. Any gain or loss
realized under Section 336 will be recognized at the corporate level if the
corporation is taxed as a C corporation, but generally will not be subject to
taxation at the corporate level if the corporation is an S corporation.
Rather, such gain or loss will be passed through to the shareholders of the
S corporation under Section 1366, and in turn increase their bases in the S
corporation under Section 1367. However, if the S corporation is subject
to the built-in gain tax imposed under Section 1374, the deemed sale of the
property could trigger built-in gain tax at the corporate level.
3. Beware of Section 1239. Because Section 336(a) provides that the
property is treated as sold to the distributee at its fair market value, any
gain attributable to depreciable property distributed to a shareholder
owning more than 50% of the stock of the corporation may be subject to
ordinary income, rather than capital/Section 1231 gain. Although this may
not be important in the C corporation context since C corporations do not
enjoy special capital gain rates, Section 1239 can have a significant impact
on S corporations since the gain would flow through to the shareholders as
ordinary income rather than as capital gain, and could cause a
mismatching of ordinary income against capital loss. This poses a
significant trap for the unwary.
4. Deductibility of Loss on Liquidation. The corporation, whether a C or S
corporation, will be allowed to deduct any losses on the deemed sale (to
the extent the adjusted tax basis to the corporation of its assets exceeds the
fair market value of such assets at the time of the distribution), with the
following exceptions:
a. Under Section 336(d)(1), no loss will be allowed on distributions
to a more than 50% shareholder, unless the distribution is pro rata
and the property was not acquired in a tax-free contribution
transaction during the preceding 5-year period.
b. Under Section 336(d)(2), the IRS could disallow a loss on
previously contributed property if “a” principal purpose of the
contribution of that property was to recognize loss in connection
with the liquidation.
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C. Tax Consequences to the Shareholder.
1. Recognition of Gain or Loss. In addition to corporate-level gain or loss,
under Section 331(a), the shareholder will recognize gain or loss to the
extent the fair market value of the assets distributed to the shareholder
exceeds such shareholder’s basis in the stock of the corporation or loss to
the extent the shareholder’s adjusted tax basis in the stock of the
corporation exceeds the fair market value of the property distributed to the
shareholder. Any shareholder-level gain will constitute capital gain or
loss if the shareholder has held his stock for more than one year. Section
1222.
2. C Corporations Versus S Corporations. Although both C corporation
and S corporation shareholders will recognize gain or loss at the
shareholder level, there should generally only be one level of tax in the
event the corporation is an S corporation because any gain recognized at
the corporate level under Section 336 will pass through to the shareholder
under Section 1366(a) and increase such shareholder’s basis in his stock
under Section 1367(a). Note, however, if ordinary income is triggered at
the corporate level, by reason of gain from inventory, depreciation
recapture or the application of Section 1239, as discussed above, any
capital loss recognized at the shareholder level may not offset the ordinary
income passed through to the shareholder under Section 1366. Under
Section 1211(b), in the case of a taxpayer other than a corporation, losses
from the sale or exchange of capital assets are allowed only to the extent
of the taxpayer’s capital gains plus up to $3,000 of ordinary income per
year.
3. Qualified Subchapter S Trusts. Another possible mismatching of gain
and loss could occur in the case of the sale of S corporation stock by a
qualified subchapter S trust (QSST), if the gain passing through from the S
corporation is taxable to the current income beneficiary, whereas the loss
on liquidation is taxable to the trust itself. However, the IRS has made it
clear that both the loss and the corresponding gain in such situations
should be reported by the QSST. See PLR 9721020 (Feb. 20, 1997),
which provides that if an S corporation liquidates, the trust should report
both (a) the Section 331 gain or loss on the stock; and (b) the Section 336
gain or loss that passes through from the corporation.
VI. CHANGING A CORPORATION INTO A PARTNERSHIP
A. In General. As discussed above, whether achieved through an actual liquidation
of the corporation and transfer of the assets of the liquidated corporation to a
newly formed partnership or LLC taxed as a partnership, the conversion of a
corporation to a partnership or LLC taxed as a partnership under the applicable
state law formless conversion statute, the merger of a corporation into an LLC
taxed as a partnership under the applicable state law merger statute, or the filing
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of a Form 8832 changing the classification of an eligible entity taxed as an
association to an entity taxed as a partnership, such de-incorporation
transactions will be treated as a liquidation of the corporation on which gain or
loss is recognized at the corporate level under Section 336 and at the shareholder
level under Section 331. Unlike the change of a corporation wholly owned by a
single shareholder into a single-member LLC or sole proprietorship, however, the
change of a corporation with multiple shareholders into an entity taxed as a
partnership will involve a second step involving the formation of the new
partnership. Although there is no corollary to Rev. Rul. 84-111 in the de-
incorporation context (as opposed to the incorporation context), the form selected
by the taxpayers should be respected by the IRS for tax purposes. In other words,
taxpayers may be free to choose among the three alternative approaches -- assets
up, assets over, and interests over -- available in partnership incorporation
transactions in connection with de-incorporation transactions.
B. “Assets Up” Approach for De-Incorporation Transactions. In the absence of
specifically structuring the transaction otherwise, most practitioners would agree
that the “assets up” approach would most likely be applied to the changing of an
entity from corporation status to partnership status. Under this approach, the
corporation will be treated as first liquidating by distributing all of its assets,
subject to its liabilities, to its shareholders. The second step would be the transfer
of the assets received by the shareholders from the corporation to the transferee
partnership (or LLC taxed as a partnership) in exchange for partnership interests.
The “assets up” approach would seem the most straightforward and intuitive
approach for the change in entity status of a corporation into a partnership. In
PLR 9701032 (Oct. 3, 1996) and PLR 7802043 (Oct. 17, 1977), the IRS applied
the “assets up” approach in situations where the transactions were actually
structured as “assets up” transactions. Additionally, PLR 8837068 (June 22,
1988), the IRS applied the “assets up” approach where the transaction was
actually structured as an “assets over” transaction.
1. Tax Consequences to Corporation on First Step of Transaction:
Distribution of Assets to Shareholders in Liquidation of Corporation.
a. Under the general rule of Section 336(a), gain or loss will be
recognized to the liquidating corporation on the distribution of
property in complete liquidation as if such property were sold to
the distribute at its fair market value.
b. In the case of a C corporation, the gain or loss will be recognized
at the corporate level, and in the case of an S corporation, the gain
or loss will generally flow through to the shareholders under
Section 1366(a), unless the corporation is subject to the built-in
gain tax imposed under Section 1374.
c. As discussed above, because Section 336(a) provides that the
property is treated as sold to the distribute at its fair market value,
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any gain attributable to depreciable property distributed to a
shareholder owning more than 50% of the stock of the corporation
may be characterized as ordinary income, rather than
capital/Section 1231 gain, pursuant to Section 1239.
d. Losses will generally be allowed to the extent the corporation’s tax
basis in the property exceeds it fair market value, provided,
however, that under Section 336(d)(1), no loss is allowed on
distributions to a more than 50% shareholder, unless the
distribution is pro rata and the property was not acquired in a tax-
free contribution transaction during the preceding 5-year period,
and under Section 336(d)(2), no loss is allowed on previously
contributed property if “a” principal purpose of the contribution of
such property was to recognize loss in connection with the
liquidation.
2. Tax Consequences to Shareholders on First Step of Transaction.
a. Also, as discussed above, in addition to the gain or loss recognized
at the corporate level, the deemed or actual liquidation will be
taxable to the shareholders under Section 331(a), regardless of
whether the corporation is a C or S corporation. Gain or loss at the
shareholder level will again be capital gain or loss provided that
the stock has been held for more than one year. Additionally, as
discussed above, for S corporations, unlike C corporations, there
should generally be only one level of tax because gain recognized
at the corporate level will pass through to the shareholders under
Section 1366(a) and increase basis at the shareholder level under
Section 1367(a). Again, however, ordinary income could be
triggered at the corporate level from depreciation recapture,
inventory or the application of Section 1239, which would result in
not being able to offset capital losses at the shareholder level
against the ordinary income at the corporate level passed through
to the shareholders under Section 1366(a).
b. Under Section 334(a), the shareholders will receive a fair market
value basis in the assets received in liquidation of the corporation.
3. Tax Consequences to Partners on Second Step of Transaction:
Contribution of Assets Received in Liquidation of Corporation by
Former Shareholders to Partnership.
a. Under the second step of the “assets up” approach, the
shareholders will be treated as having contributed their assets
received in liquidation of the corporation to the partnership. In
general, no gain or loss should be recognized on the contribution of
the assets received in liquidation to the partnership because the
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assets being contributed will have a full fair market value basis
under Section 334(a), and Section 721(a) generally provides that
no gain or loss is recognized to the partners upon a contribution of
property to the partnership. Possible exceptions to the partners not
recognizing gain or loss could include:
(1) the “investment company” rules under Section 721(b), or
(2) gain recognized as the result of a constructive distribution
under Section 752(b) where a partner has a net reduction in
liabilities as part of the partnership formation transaction in
excess of his adjusted basis in the assets contributed to the
partnership.
b. Each partner’s basis in his partnership interest should be equal to
the adjusted basis of the assets contributed (which will be their fair
market value under Section 334(a)), and a new holding period for
the partnership interests would start on such date under Section
1223(1).
4. Tax Consequences to Partnership on Second Step of Transaction.
a. The partnership will generally recognize no gain or loss on its
receipt of the assets received by the shareholders in liquidation of
the corporation to the partnership under Section 721(a).
b. Additionally, the partnership should receive a carryover basis in
the contributed assets (equal to their fair market value).
c. The holding period for the contributed assets will begin on the date
of receipt by the partnership of such assets from the partners under
Section 1223(2).
C. “Assets Over” Approach for De-Incorporation Transaction. Under this
approach, the corporation first will be treated as transferring its assets, subject to
its liabilities, to a newly organized partnership in exchange for partnership
interests, and in the second step of the transaction, the corporation would liquidate
by distributing the partnership interests to its shareholders, which would result in
the individual shareholders becoming the partners of the partnership. Because the
newly-formed partnership would be momentarily wholly-owned by the
corporation before the distribution of the partnership interests in liquidation of the
corporation, a question arises as to whether a separate partnership entity actually
exists, rather than a disregarded entity. Consequently, the application of the
“assets over” approach on a de-incorporation transaction is conceptually
problematic. As a result of this issue, some practitioners seeking “assets over”
treatment in the context of a de-incorporation transaction form a bona fide
partnership with one or more outside partners as part of the first step of the “assets
24
over” approach. See PLR 200214016 (Dec. 21, 2001); PLR 9701029 (Oct. 2,
1996); and PLR 9543017 (July 26, 1995).
1. Tax Consequences to Corporation on First Step of Transaction:
Transfer of Assets to the Partnership in Exchange for Partnership
Interests.
a. On the transfer of the corporation’s assets to the partnership, no
gain or loss would be recognized by the corporation under Section
721(a) if the entity is treated as a partnership. Alternatively, no
gain or loss should be recognized if the entity is treated as a
disregarded entity since no taxable transaction occurs upon the
transfer by the corporation of its assets to a disregarded entity.
b. Under Section 722, the corporation should receive a basis in the
partnership interests equal to the corporation’s basis in the assets it
contributed to the partnership.
c. Under Section 1223(1), the corporation should be able to “tack”
the holding period of the contributed assets to its holding period
for the partnership interest to the extent the partnership interests
were received in exchange for capital/Section 1231 assets.
2. Tax Consequences to Partnership on First Step of Transaction.
a. In general, the partnership will not recognize gain or loss on the
contribution of the assets by the corporation to the partnership.
b. Although certainly not as clear as the “assets up” approach
discussed above, under the “assets over” approach, the new
partnership may not receive a stepped-up basis in its initial assets
under Section 723. To the extent the assets contributed by the
corporation to the partnership receive a carryover basis, the new
partnership should be able to continue to depreciate the old basis in
the same manner as the predecessor corporation and the
partnership should also receive tacking of the corporation’s
holding period with respect to any assets having a carryover basis
pursuant to Section 1223(2).
3. Tax Consequences to Corporation on Second Step of Transaction:
Distribution of Partnership Interests in Liquidation of Corporation.
a. The second step in the “assets over” approach would be a fully
taxable liquidation of the corporation under Section 336(a) by
distribution of the new partnership interests received by the
corporation to the shareholders of the corporation in liquidation of
the corporation.
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b. Because partnership interests rather than assets are being
distributed in the deemed liquidation, the gain should be capital
except to the extent attributable to Section 751 assets. Similarly,
depreciation recapture might be avoided and Section 1239 ordinary
income treatment might be avoided since partnership interests are
non-depreciable as opposed to the distribution of depreciable
assets.
4. Tax Consequences to Shareholders on Second Step of Transaction.
a. Under Section 331(a), the shareholders will be subject to taxation
to the extent the fair market value of the partnership interests
exceeds their basis in the stock of the corporation.
b. Under Section 334(a), the former shareholders of the corporation
would receive a fair market value basis in the partnership interests
received in liquidation of the corporation. The shareholders may
be able to make a Section 754 election to trigger an upward basis
adjustment of the assets inside the partnership on the taxable
corporate liquidation. See PLR 9701029 (Oct. 2, 1996); and PLR
9543017 (July 26, 1995). This would address the concerns
discussed in VI.C.2.b. above regarding the partnership not
receiving a stepped-up basis in the assets.
D. “Interests Over” Approach. Under the third approach, the shareholders would
actually transfer their stock to the transferee partnership in exchange for
partnership interests, and the corporation would then be liquidated into the
partnership.
1. Tax Consequences to Shareholders on First Step of Transaction:
Contribution of Stock to Partnership in Exchange for Partnership
Interests.
a. Under this approach, no gain or loss should be recognized by the
shareholders on the transfer of their stock to the partnership in
exchange for partnership interests under Section 721(a).
b. Under Section 722, the shareholders should receive a substituted
basis in their partnership interests equal to the basis they had in
their stock of the corporation and should receive a tacking of the
holding periods for such partnership interests under Section
1223(1).
c. A major pitfall of the “interests over” approach is that if the
corporation is an S corporation, the momentary ownership of the
corporation’s stock by the partnership in the first step of the
transaction may terminate the corporation’s S corporation election.
This in turn will result in double taxation as a result of the inability
26
to pass through any gain recognized by the corporation on the
second step of the transaction to its shareholders under Section
1366, and in turn, increasing their basis under Section 1367.
2. Tax Consequences to Partnership on First Step of Transaction.
a. Under Section 721(a), no gain or loss should be recognized by the
partnership on the contribution of the stock to the partnership by
the shareholders of the corporation in exchange for partnership
interests.
b. Under Section 723, the partnership’s basis in the stock of the
corporation should be the adjusted basis of the stock to the
shareholders at the time of the contribution (a “substituted” or
“transferred” basis).
c. Under Section 1221(2), the partnership should be able to “tack” the
holding period for which the shareholders held the stock of the
corporation to its holding period for the stock.
3. Tax Consequences to Corporation on Second Step of Transaction:
Liquidation of Corporation by Distribution of Assets to the
Partnership.
a. The corporation would recognize gain or loss under Section 336(a)
on the second step of the “interests over” approach as its assets will
be treated as distributed to the partnership in liquidation of the
corporation.
b. If the corporation was an S corporation, and the momentary
ownership of the corporation’s stock by the partnership terminates
the corporation’s S status as discussed above, the liquidation would
result in double taxation on the liquidation the same as if the
corporation were a C corporation.
4. Tax Consequences to Partnership on Second Step of Transaction.
a. Under Section 331(a), the partnership will recognize gain or loss to
the extent the fair market value of the assets received by it in
liquidation of the corporation exceeds the partnership’s basis in the
stock of the corporation.
b. Under Section 334(a), the partnership will have a fair market value
basis in the assets it receives in liquidation of the corporation.
c. Finally, if the shareholders’ respective adjusted bases in their stock
of the corporation differ, Section 704(c) should apply to allocate
27
the gain on the liquidation in proportion to the appreciation in their
respective stock holdings.
E. Check-the-Box Regulations. If an eligible entity has elected to be treated as an
association taxed as a corporation, and makes an election on Form 8832 to change
its classification to that of a partnership, Treas. Reg. §§ 301.7701-3(g)(1)(ii) and
(iii) expressly provide that the “assets up” treatment will apply.
F. State Law Formless Conversion Statute. Unlike Rev. Rul. 2004-59, which
specifies the treatment of the conversion of a partnership into a corporation under
the applicable state law conversion statute, there is no clear guidance on how a
liquidation should be treated when it is effectuated through the conversion of a
corporation into a partnership or LLC taxed as a partnership under the applicable
state law formless conversion statute. However, a number of private letter rulings
have applied “assets up” treatment in such cases. See, e.g., PLR 200129029
(April 20, 2001) (“assets up” approach applied to conversion of a subsidiary
corporation into a limited liability company); and PLR 9401014 (Oct. 7, 1993)
(“assets up” approach applied on apparent conversion of foreign subsidiary into
foreign partnership).
G. Cross-Entity Merger Statute. There is no clear guidance on how the deemed
liquidation should occur when a corporation is merged into a limited liability
company taxed as a partnership under an applicable state law cross-entity merger
statute. However, a number of private letter rulings have used the “assets over”
approach where a corporation has been merged into an LLC taxed as a partnership
pursuant to applicable state law cross-entity merger statutes. See, e.g., PLR
200628008 (March 28, 2006) (merger of two S corporations into a limited
liability company utilizes “assets over” approach); PLR 200606009 (Oct. 17,
2005) (merger of a corporation into a limited liability company electing to be
treated as a partnership utilizes “assets over” approach); PLR 200333020 (May 6,
2003) (merger of corporate subsidiaries into partnerships utilizes “assets over”
approach); PLR 200310026 (August 27, 2002) (merger of parent corporation into
subsidiary partnership utilizes “assets over” approach); PLR 200214016 (Dec. 21,
2001) (merger of a corporation owned by two higher tiered corporations into a
limited liability company utilizes “assets over” approach); PLR 9701029 (Oct. 2,
1996) (merger of a C corporation into a limited liability company with a Section
754 election utilizes “assets over” approach); PLR 9543017 (July 26, 1995)
(merger of S corporation into limited liability company with a Section 754
election utilizes “assets over” approach); PLR 9409016 (Nov. 30, 1993), 9409014
(Nov. 29, 1993), and 9404021 (Nov. 1, 1993) (merger of corporate subsidiary into
subsidiary partnership utilizes “assets over” approach).
VII. CONVERSIONS OF A DISREGARDED ENTITY INTO A PARTNERSHIP AND
A PARTNERSHIP INTO A DISREGARDED ENTITY
A. In General. The acquisition of a disregarded entity by a single buyer is treated
for federal income tax purposes as the sale of assets by the owner of the
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disregarded entity which neither elected or converted to association status. The
check-the-box regulations do not address a change in tax status caused by a
change in number of members, but this subject has been addressed by the IRS in
two well-known rulings: Rev. Rul. 99-5, 1999-1 C.B. 434 (increase in number of
owners of disregarded entity from one to two or more), and Rev. Rul. 99-6, 1999-
1 C.B. 432 (sale of membership interest in a partnership to a single purchaser
resulting in the conversion to a disregarded entity).
B. Conversion of a Disregarded Entity into a Partnership: Increase From One
Member to Two (or More) Members. In Rev. Rul. 99-5, supra. two scenarios
involving the conversion of a disregarded entity into a partnership are discussed.
In both cases, A owns 100% of the interests in an LLC valued at $10,000 and B
purchases a 50% interest from A.
1. In situation one, B acquires the interest from A for $5,000. The
transaction is treated as a sale of one-half of each asset to B, followed by a
contribution of all of the assets by A and B to a new partnership. A
recognizes gain or loss on the sale of each asset held by the LLC.
2. In situation two, B acquires a new 50% interest in the LLC from the LLC
for $10,000 and the proceeds of the sale are retained in the business of the
LLC. The transaction is treated as a transfer of all of the assets by A to a
new partnership for an interest in the partnership, and a transfer of cash by
B to the new partnership. No gain or loss, in general, is recognized by
either party under Section 721.
3. What if A transfers an interest in the LLC to B, but A contributes the cash
to the business, so that their interests were 2/3 to A and 1/3 to B? Would
the form of the transaction be followed, resulting in gain to A on an asset
sale to B, or would the transaction be treated as a subscription by B to a
1/3 interest in the resulting partnership, resulting in nontaxable Section
721 treatment to A? See Monte A. Jackel, “New Rulings Address One-to-
Two and Two-to-One Entity Conversions”, 82 Tax Notes 1167 (Feb. 22,
1999).
4. What if B purchases his interest directly from the LLC but cash is
distributed to A? Presumably the disguised sales rules under Section
707(a)(2)(B) would apply. This result could also occur if A caused new
liabilities to be assumed by the new entity.
5. Other Consequences. Each version will have a varying outcome with
respect to: (i) basis; (ii) holding period; (iii) Section 704(c) attributes and
possibly with respect to Section 197.
C. Conversion of a Partnership into A Disregarded Entity: Purchase of All of
the Interests in an LLC Taxable as a Partnership by One Buyer.
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1. In Rev. Rul. 99-6, the IRS addressed the purchase of all of the interests in
an LLC taxed as a partnership by a single purchaser, resulting in a
conversion to an single-member LLC.
2. In situation one, A and B are each equal 50% owners of an LLC. B
purchases A’s interest in the LLC for 10X and continues to operate the
business as a single member LLC. The ruling concludes that: (i) the
partnership terminates under Section 708(b)(1)(A); (ii) A, under Section
741, is treated as selling his partnership interest to B; and (iii) B, however,
is treated as if the LLC first made a liquidating distribution of all of its
assets to A and B and then B acquired the assets deemed distributed to A
for full monetary consideration paid. B would therefore have a carryover
basis in 1/2 of the assets (his pre-purchase share and tacking of holding
period for his interest) and a fair market value purchase price basis in 1/2
of the assets deemed purchased from A with a new holding period.
3. In situation two, C and D are equal partners in CD, an LLC. C and D sell
their entire interests in CD to E, an unrelated person, for $10X each. The
business is continued by the LLC, which is owned solely by E. The IRS
concluded: (i) the CD partnership terminates under Section 708(b)(1)(A);
(ii) C and D must report gain or loss under Section 741; (iii) the CD
partnership is deemed to make a liquidating distribution of its assets to C
and D; and (iv) immediately thereafter, E is deemed to acquire, by
purchase, all of the former partnership’s assets. E has a cost basis of $20X
in the assets and a new holding period. Compare Rev. Rul. 84-111, 1984-
2 C.B. 88 (Situation 3), which determines the tax consequences to a
corporate transferee of all interests in a partnership in a manner consistent
with McCauslen v. Comm’r, 45 T.C. 588 (1966), and holds that the
transferee’s basis in the assets received equals the basis of the partnership
interests, allocated among the assets in accordance with Section 732(c).
VIII. CONVERSION OF A C CORPORATION INTO AN S CORPORATION
A. The Built-In Gain Tax Hurdle and Other Pitfalls of Conversion. Although a
corporation which converts from C corporation to S corporation status may enjoy
considerable tax and other benefits attributable to its S status, the conversion
process is fraught with potential pitfalls. These include the potential imposition
of the excess passive investment income tax under Section 1375 and the possible
termination of the corporation’s S election under Section 1362(d), the imposition
of the LIFO recapture tax under Section 1363(d), the potential application of the
distribution rules applicable to S corporations having subchapter C earnings and
profits under Section 1368(c), the loss of net operating loss carryovers under
Section 1371(b) and the imposition of the built-in gain tax under Section 1374.
Generally, the greatest exposure facing a corporation upon conversion to S
corporation status is the imposition of the built-in gain tax under Section 1374.
This problem will be especially acute with respect to the corporation that reports
its income under the cash method of accounting. A brief discussion of the
30
mechanics of the built-in gain tax will ensue and will be followed by an
examination of the special problems facing the cash-basis corporation converting
to S corporation status.
B. General Built-In Gain Tax Rules.
1. Section 1374 imposes a corporate-level tax on the built-in gain of S
corporations that were previously C corporations. Section 1374 as
originally enacted applies to built-in gain recognized by a corporation
during the 10-year period following such corporation’s conversion to S
status. Section 1374(d)(7). Treas. Reg. § 1.1374-1(d) provides that the
recognition period is the ten-calendar year period, and not the ten-tax year
period, beginning on the first day the corporation is an S corporation or the
day an S corporation acquires assets under Section 1374(d)(8) in a
carryover basis transaction. The tax rate is presently 35% (the highest rate
of tax imposed under Section 11(b)) of the S corporation’s “net recognized
built-in gain.” Section 1374(b)(1).
2. On September 27, 2010, President Obama signed into law the Small
Business Jobs Act of 2010, H.R. 5297. Section 2014 of the Act amends
Section 1374 to provide for the reduction of the recognition period during
which corporations that converted from C corporation status to S
corporation status are subject to the built-in gain tax from 10 years to 5
years for taxable years beginning in 2011. Specifically, the text of the
amendment is very similar to the temporary reduction from 10 years to 7
years made by the American Recovery and Reinvestment Act of 2009.
Pub. L. No. 111-5, 123 Stat. 115 (2/17/2009) The text of the amendment
reads as follows:
(b) Special Rules for 2009, 2010 and 2011. - No
tax shall be imposed on the net recognized built-in
gain of an S corporation - (i) in the case of any
taxable year beginning in 2009 or 2010, if the 7th
taxable year in the recognition period preceded such
taxable year, or (ii) in the case of any taxable year
beginning in 2011, if the 5th year in the recognition
period preceded such taxable year.
3. The amendment is applicable to taxable years beginning after December
31, 2010, and generally raises the same questions as were raised in
connection with the reduction from 10 years to 7 years for taxable years
beginning in 2009 and 2010. For a discussion of these issues, see Looney
and Levitt, “Reasonable Compensation and The Built-In Gains Tax,” 68
NYU Fed. Tax. Inst., ¶15.05[1][a], [b]. [c] and [d] (2010). However, it
should be noted that the proposed amendment specifically uses the term
“taxable year” in connection with the recognition period for taxable years
beginning in 2009 and 2010, but only uses the term “5th year” (not taxable
31
year) in connection with the recognition period for a taxable year
beginning in 2011. This appears to resolve any ambiguity created by the
previous amendment and clarifies that for dispositions in 2009 and 2010, 7
tax years (including short tax years) need to have transpired prior to the
year of disposition for the built-in gain tax not to apply to such
dispositions, and that for dispositions in 2011, 5 calendar years need to
have transpired prior to the year of disposition for the built-in gain tax not
to apply to such dispositions.1
C. NUBIG Limitation.
1. Section 1374(c)(2) provides that the net recognized built-in gain taken into
account under Section 1374 for any tax year may not exceed the NUBIG
of all the corporation’s assets less the built-in gain recognized by the
corporation in prior years during the recognition period. Section
1374(d)(1) provides that NUBIG is the amount by which the fair market
value of all the corporation’s assets as of the beginning of its first tax year
as an S corporation exceeds the corporation’s aggregate adjusted tax bases
in such assets at such time. Treas. Reg. § 1.1374-3(a) provides a more
expansive definition of NUBIG as the total of the following amounts:
a. The amount that would be the amount realized if on the first day of
the recognition period the corporation sold all of its assets at fair
market value to an unrelated party which assumed all of its
liabilities; decreased by
b. Any liability of the corporation that would be included in the
amount realized but only if the corporation would be allowed a
deduction on payment of such liability; decreased by
c. The aggregate adjusted bases of the corporation’s assets on the first
day of the recognition period; increased or decreased by
d. The corporation’s Section 481 adjustments on the first day of the
recognition period; and increased by
e. Any recognized built-in loss that would not be allowed under
Section 382, 383 or 384.
1 The differences between the express statutory language and the Committee Reports accompanying
the 2009 Act raised the issue of whether Congress actually intended to use tax years rather than calendar
years in measuring the 7-year recognition period. In fact, Section 2(h) of the Tax Technical Corrections
Act of 2009, H.R. 4169, 111 Congress, 1st Session, which was introduced on December 2, 2009, but
which did not pass, would have changed the phrase “7th taxable year” to “7th year” in Section
1374(d)(7)(B) retroactively for tax years beginning after 2008. With the passage of the Small Business
Jobs Act of 2010, it appears that Congress has conceded that tax years will apply to the special 7-year rule
applicable to dispositions in 2009 and 2010 but that calendar years will be used for the special 5-year rule
applicable to dispositions made in 2011.
32
2. Pursuant to the NUBIG limitation, the maximum amount of built-in gain
subject to tax under Section 1374 is generally limited to the amount of
pre-C to S conversion appreciation in the corporation’s assets and does not
include any post-C to S conversion appreciation in such assets.
3. Section 1374(d)(5)(C) also provides that a corporation’s NUBIG is to be
properly adjusted for amounts which would be treated as built-in gain
under Section 1374(d)(5)(A) or as built-in losses under Section
1374(d)(5)(B). These built-in gain and loss items are included in the
computation of NUBIG without regard to when or whether such items are
actually recognized during the recognition period.
D. Taxable-Income Limitation.
1. In addition to the limitation placed on the aggregate amount of net built-in
gain that may be recognized by an S corporation under the NUBIG
limitation, the taxable-income limitation limits the amount of net built-in
gain recognized by an S corporation on an annual basis. Because a
corporation’s taxable income may serve as the base for the built-in gain
tax, the maximum amount of net built-in gain (built-in gain less built-in
losses) that must be recognized by an S corporation in a particular tax year
within the BIG Period is limited to the amount of the corporation’s taxable
income for such year (the taxable-income limitation). Section
1374(d)(2)(A)(ii) and Treas. Reg. § 1.1374-2(a)(2).
2. Any recognized built-in gain that is not subject to the built-in gain tax
because of the taxable income limitation must be carried forward and is
subject to the built-in gain tax in the S corporation’s succeeding tax years
to the extent that it subsequently has other taxable income (that is not
already subject to the built-in gain tax) for any tax year within the BIG
Period. Section 1374(d)(2)(B), as amended by Section 1006(f)(5) of the
Technical and Miscellaneous Revenue Act of 1988 (TAMRA), Pub. L.
No. 100-647, 102 Stat. 3342 (1988). This modification reduced potential
manipulation of timing post-conversion losses to avoid the built-in gain
tax on the corporation’s NUBIG, and applies only to corporations filing S
elections on or after March 31, 1988.
E. Built-In Income and Built-In Deduction Items.
1. Under Section 1374(d)(3), an S corporation’s recognized built-in gain
includes gain recognized from the “disposition” of any asset. The
legislative history of the Technical and Miscellaneous Revenue Act of
1988 (TAMRA) clarified that the “disposition of any asset” includes not
only sales and exchanges, but also other income recognition events that
effectively dispose of, or relinquish, the taxpayer’s right to receive
income. H. R. Rep. No. 795, 100th Cong., 2d Sess. 63 (1988). See also
Ann. 86-128, 1986-51 I.R.B. 5. Specifically, Section 1374(d)(5)(A)
33
provides that any item of income that is properly taken into account during
the recognition period but which is “attributable” to periods prior to the
date of the corporation’s conversion to S status will be treated as a
recognized built-in gain for the tax year in which it is properly taken into
account. This type of item is generally referred to as a “built-in income
item.” Similarly, Section 1374(d)(5)(B) provides that any amount which
is allowable as a deduction during the recognition period but which is
“attributable” to a period prior to the date of the corporation’s conversion
to S status will be treated as a recognized built-in loss for the tax year for
which it is allowable. This type of item is generally referred to as a “built-
in deduction item.” In determining whether an item constitutes a built-in
income or built-in deduction item under Sections 1374(d)(5)(A) and
1374(d)(5)(B), the focus is therefore on whether such item is
“attributable” to a period prior to the date of the corporation’s conversion
to S status.
2. The IRS adopted an “accrual method rule” in determining whether an
income item or a deduction item is attributable to a period prior to the date
of the corporation’s conversion to S status. Specifically, Treas. Reg. §
1.1374-4(b)(1) provides that any item of income properly taken into
account during the recognition period is recognized built-in gain if the
item would have been included in gross income before the beginning of
the recognition period by a taxpayer using the accrual method of
accounting. The most common example of a built-in income item subject
to the built-in gain tax is the collection of accounts receivable by a cash-
basis taxpayer. Likewise, Treas. Reg. § 1.1374-4(b)(2) provides that any
item of deduction properly taken into account during the recognition
period is recognized built-in loss if the item would have been properly
allowed as a deduction against gross income before the beginning of the
recognition period by a taxpayer using the accrual method of accounting.
The most common example of a built-in deduction item is the payment of
accounts payable by a cash-basis taxpayer. Consequently, the benchmark
for whether an item constitutes a built-in income or built-in deduction item
under Section 1374(d)(5), is whether such item would have been
includable in income, or allowed as a deduction, prior to the corporation’s
conversion to S status if the corporation had been an accrual basis
taxpayer.
3. In determining whether an item would have been includable in income, or
allowed as a deduction, prior to the corporation’s conversion to S status if
the corporation had been an accrual basis taxpayer, the regulations
generally provide that all rules applicable to an accrual basis taxpayer
apply, specifically including Section 267(a)(2) (relating to the timing of
deductions by an accrual basis payor with respect to a cash basis payee
that is a related party), and Section 404(a)(5) (relating to the timing of
deductions for deferred compensation).
34
4. Section 267(a)(2) generally prohibits an accrual basis taxpayer from
deducting an item payable to a cash basis payee until the amount is
includable in the cash basis payee’s income if the payor and payee are
related within the meaning of Section 267(b).
5. Similarly, Section 404(a)(5) generally prohibits a corporation from taking
a deduction for any amounts deferred under a non-qualified deferred
compensation plan, until such amounts are includable in the employee’s
gross income.
6. Many commentators objected to the IRS’s application of Sections
267(a)(2) and 404(a)(5) to preclude treatment of an item as a built-in
deduction under Section 1374(d)(5)(B). Specifically, H. R. Rep. No. 100-
795, 100th Cong., 2d Sess. 63-64, which accompanied TAMRA, provides
the following:
“As an example of these built-in gain and loss
provisions, in the case of a cash basis personal
service corporation that converts to S status and that
has receivables at the time of the conversion, the
receivables, when received, are built-in gain items.
At the same time, built-in losses would include
otherwise deductible compensation paid after the
conversion to the persons who performed the
services that produced the receivables, to the extent
such compensation is attributable to such pre-
conversion services. To the extent such built-in loss
items offset the built-in gain from the receivables,
there would be no amount subject to the built-in
gain tax.”
7. In determining whether an item would be deductible by an accrual basis
taxpayer for purposes of the built-in gain tax, however, the regulations
modify the rules generally applicable to accrual basis taxpayers in three
respects. First, Treas. Reg. § 1.1374-4(c)(1) provides that any amounts
properly deducted in the recognition period under Section 267(a)(2),
relating to payments to related parties, will be treated as recognized built-
in loss to the extent that the following requirements are met:
a. All events have occurred that establish the fact of the liability to
pay the amount, and the exact amount of the liability can be
determined, as of the beginning of the recognition period; and
b. The amount is paid in the first two and one-half months of the
recognition period or is paid to a related party owning (under the
attribution rules of Section 267) less than 5% (by voting power and
35
value) of the corporation’s stock, both as of the beginning of the
recognition period and when the amount is paid.
8. Additionally, Treas. Reg. § 1.1374-4(c)(2) provides that any amount
properly deducted in the recognition period under Section 404(a)(5),
relating to payments for deferred compensation, will be treated as
recognized built-in loss to the extent that the following requirements are
met:
a. All events have occurred that establish the fact of the liability to
pay the amount, and the exact amount of the liability can be
determined, as of the beginning of the recognition period; and
b. The amount is not paid to a related party to which Section
267(a)(2) applies.
9. The regulations also provide that in determining whether an item would
have been properly allowed as a deduction against gross income by an
accrual method taxpayer, Section 461(h)(2)(C) (which provides that
economic performance does not occur for tort liabilities or worker’s
compensation liabilities until payment has been made), and Treas. Reg.
§ 1.461-4(g) (which provides that economic performance does not occur
for liabilities arising out of breach of contract, violation of law, rebates,
refunds, awards, prizes, jackpots, insurance contracts, warranty contracts,
service contracts and taxes until payment is made), do not apply. Treas.
Reg. § 1.1374-4(b)(2). Thus, to constitute a built-in deduction item within
the meaning of Section 1374(d)(5)(B), only the all events test (and not the
economic performance test) needs to be satisfied with respect to the
liabilities referred to in Section 461(h)(2)(C) and Treas. Reg. § 1.461-4(g).
10. Treas. Reg. §§ 1.446-1(c)(1)(ii) and 1.451-1(a), provide that accrual
method taxpayers recognize income for the tax year in which the
following two requirements are met:
a. All of the events have occurred that fix the right to receive such
income; and
b. The amount thereof can be determined with reasonable accuracy.
11. Similarly, Treas. Reg. §§ 1.446-1(c)(1)(ii) and 1.461-1(a)(2) provide that
under the accrual method of accounting, deductions are allowable for the
tax year in which:
a. All of the events have occurred that establish the fact of the
liability giving rise to such deduction; and
b. The amount thereof can be determined with reasonable accuracy.
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12. Under Section 461(h)(1), the “all events” test is not considered to be met
any earlier than when economic performance with respect to such item
occurs. In circumstances involving services or property provided to a
taxpayer, economic performance is deemed to occur under Section
461(h)(2)(A) when the person provides such services or provides such
property to the taxpayer. In circumstances where the liability of a
taxpayer requires the taxpayer to provide services or property to another
person, economic performance is deemed to occur under Section
461(h)(2)(B) as the taxpayer provides such property or services.
F. Effect of Classification of Item as Built-in Income or Built-In Deduction
Item.
1. An item that is classified as a built-in income item will be treated as a
recognized built-in gain when taken into account by the S corporation
during the BIG Period, and thus, potentially be subject to the built-in gain
tax imposed under Section 1374. Section 1374(d)(5)(A). Under Section
1374(d)(5)(C), a built-in income item also has the effect of increasing the
corporation’s NUBIG. Likewise, an item that is classified as a built-in
deduction item will be treated as a recognized built-in loss when allowed
as a deduction to the S corporation during the recognition period, and thus,
will be available to offset any built-in gain recognized by the S
corporation during such tax year. Section 1374(d)(5)(B). A built-in
deduction item also has the effect of decreasing the corporation’s NUBIG
under Section 1374(d)(5)(C).
2. Even if an item does not constitute a built-in loss item within the meaning
of Section 1374(d)(5)(B), it still may potentially affect a corporation’s
NUBIG. For example, an accrued bonus payable to a C corporation’s sole
shareholder-employee that is not paid by the corporation within the first
two and one-half months following the date of its conversion to S status
would not constitute a built-in deduction item under 1374(d)(5)(B) since,
under both Sections 267(a)(2) and 404(a)(5), such amount would not have
been deductible by the corporation prior to the date of its conversion if it
were an accrual basis taxpayer. The accrued bonus would, however, still
serve to reduce the corporation’s NUBIG limitation since Treas. Reg. §
1.1374-3(a)(2) provides that NUBIG is decreased by the amount of any
liability of the corporation to the extent the corporation would be allowed
a deduction on payment of such liability. In other words, the accrual
method rule does not apply in determining whether a liability decreases a
corporation’s NUBIG.
3. Example 1. Assume a cash-basis corporation owns two buildings
(Building “A” and “Building “B”), each of which has a built-in gain
(excess of fair market value over basis as of the date of conversion to S
status) of $100. Additionally, assume that prior to the corporation’s
conversion to S status, the corporation accrued a bonus to its sole
37
shareholder-employee of $50. In its initial S year, the corporation sells
Building “A” generating a recognized built-in gain of $100, pays the $50
accrued bonus to its shareholder-employee following the first two and
one-half months of such year, and has other taxable income of $100.
4. Because the accrued bonus was not paid within the first two and one-half
months following the corporation’s conversion to S status, the accrued
bonus will not constitute a recognized built-in deduction item under
Section 1374(d)(5)(B). As such, the corporation’s pre-limitation amount
(the amount which would be its taxable income if only recognized built-in
gain and recognized built-in losses were taken into account) will be $100.
If the accrued bonus had been treated as a built-in deduction item,
however, the corporation’s pre-limitation amount would only have been
$50 ($100 recognized built-in gain on the sale of Building “A” less $50
recognized built-in loss on payment of the bonus). The accrued bonus
will, however, decrease the corporation’s NUBIG to $150 ($100 built-in
gain on Building “A” plus $100 built-in gain on Building “B” less $50
liability for accrued bonus). Thus, if Building “B” is sold during the BIG
Period and results in a recognized built-in gain of the full $100, only $50
will be subject to the built-in gain tax under Section 1374, and the only
adverse consequence of the accrued bonus not being treated as a built-in
deduction item would be the acceleration of the corporation’s built-in gain
($100 gain recognized on the disposition of Building “A” rather than $50).
This example demonstrates that the effect of an item not being classified
as a built-in deduction under Section 1374(d)(5)(B), but which
nevertheless reduces NUBIG, will be greatest where the corporation has
several assets with built-in gain, only some of which are sold during the
BIG Period. In such case, the corporation will pay more built-in gain tax
than it otherwise would have paid if the item had been treated as a built-in
deduction item and had been available to offset the recognized built-in
gain of other assets. If all of the built-in gain assets are sold during the
BIG Period, the only effect of an item not being classified as a built-in
deduction item will be the acceleration of the built-in gain tax applicable
to the corporation’s assets. Finally, if none of the built-in gain assets are
sold by the S corporation during the BIG Period, there will be no adverse
effect from an item not being classified as a built-in deduction.
5. Although not as clear as in the case of a liability not qualifying as a built-
in deduction item, an item that does not constitute a built-in income item
because it would not have been recognized by the corporation prior to the
date of its conversion to S status if the corporation had been on the accrual
method of accounting, could possibly still increase the corporation’s
NUBIG limitation if such item was treated as an asset of the corporation
on the date of conversion and the item had an ascertainable fair market
value in excess of the corporation’s basis in such item on the date of
conversion. Possible examples of such items include an account
receivable subject to a substantial doubt as to collectibility and a
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contingent or potential claim against a third party. The collection of an
item that does not constitute a built-in income item under Section
1374(d)(5)(A) would not trigger application of the built-in gain tax since
the collection of such an item would not constitute a recognized built-in
gain. Assuming that such an income item increased the corporation’s
NUBIG limitation, however, the corporation’s overall exposure to the
built-in gain tax might be increased to the extent the corporation has other
built-in gain assets.
6. Example 2. Assume that a cash-basis corporation owns Building “A”,
which has a built-in gain of $100, and Building “B”, which has a built-in
loss of $100. Additionally, the corporation has an account receivable in
the face amount of $100 with respect to which there is sufficient doubt as
to its collectibility so as to preclude the corporation (had it been an accrual
basis taxpayer) from including the receivable in its income prior to the
date of its conversion to S status. Further assume that the IRS can
somehow show that the account receivable had some value (assume $20)
as of the date of the corporation’s conversion to S status, so that the
corporation’s NUBIG is increased to $20. (If the receivable actually had
an ascertainable fair market value of $20, then the receivable arguably
might also constitute a built-in income item to the extent of $20.
Bifurcating a single asset in this manner, however, seems inappropriate
and not supported by Section 1374 (or the Section 1374 regulations)).
7. In the event the corporation collects the full $100 account receivable in its
first tax year as an S corporation, such amount would not constitute a
recognized built-in gain subject to the built-in gain tax under Section 1374
since the item did not constitute a built-in income item under Section
1374(d)(5)(A). If, however, the corporation subsequently sells Building
“A” with a built-in gain of $100 during the BIG Period, the corporation
would have a net recognized built-in gain of $20 (the Corporation’s
NUBIG limitation) on which the built-in gain tax would be imposed. If,
alternatively, the account receivable had no effect on the corporation’s
NUBIG, the corporation would not have been subject to the built-in gain
tax on the disposition of Building “A” since its NUBIG would have been
zero. This example illustrates that an item which does not constitute a
built-in income item under Section 1374(d)(5)(A), but which nevertheless
increases a corporation’s NUBIG, will have its greatest impact if the
corporation has other built-in gain assets that are disposed of during the
recognition period that are not offset by corresponding dispositions of
built-in loss assets during the same tax year.
G. Section 481 Adjustments, Deemed DISC Distributions, COD Income and
Income from Completed Contract Method of Accounting.
1. Treas. Reg. § 1.1374-4(d)(1) provides that any Section 481(a) adjustment
taken into account in the recognition period that prevents an omission or
39
duplication of income or deduction will be recognized built-in gain or loss
to the extent the adjustment relates to items attributable to periods
beginning before the recognition period. Similarly, the regulations
provide that any item of income properly taken into account during the
recognition period under Section 995(b)(2) (relating to deemed
distributions from a DISC) will be treated as recognized built-in gain if the
item results from a DISC termination or a DISC disqualification occurring
before the beginning of the recognition period.
2. Treas. Reg. § 1.1374-4(f) provides that any item of income or deduction
properly taken into account during the first year of the recognition period
as discharge of indebtedness income under Section 61(a)(12) or as a bad
debt deduction under Section 166 will be treated as recognized built-in
gain or loss if the item arises from a debt owed by or to an S corporation at
the beginning of the recognition period.
3. Any item of income properly taken into account during the recognition
period under the completed contract method where the corporation began
performance of the contract prior to the beginning of the recognition
period will be treated as recognized built-in gain if the item would have
been included in gross income prior to the beginning of the recognition
period under the percentage of completion method. Additionally, any
similar item of deduction is treated as recognized built-in loss if the item
would have been allowed against gross income prior to the beginning of
the recognition period under the percentage of completion method. Treas.
Reg. § 1.1374-4(g).
H. Installment Sales.
1. Treas. Reg. § 1.1374-4(h)(1) provides that if a corporation sells an asset
either before or during the recognition period and reports income from the
sale under the installment method of accounting during or after the
recognition period, a tax is imposed under Section 1374 on such income.
2. Treas. Reg. § 1.1374-4(h)(2) provides that if a corporation is subject to
built-in gain tax under the installment rule, the taxable income limitation is
equal to the amount by which the S corporation’s net recognized built-in
gain would have been increased from the year of the sale to the earlier of
the year the income is reported under the installment method or the last
year of the recognition period, assuming all income from the sale had been
reported in the year of the sale and all provisions of Section 1374 apply.
In the event the corporation sells an asset prior to the beginning of the
recognition period, the entire amount of income to be reported from the
sale that was not reported prior to the recognition period is treated as
having been reported in the first year of the recognition period.
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3. Treas. Reg. § 1.1374-4(h)(3) provides that where the taxable income
limitation applies, the excess of the amount reported under the installment
method over the amount subject to tax under the taxable income limitation
rule is treated as if it were reported in the succeeding tax years, but only
for the succeeding tax years in the recognition period. Any carryover
amounts reported in succeeding tax years will be reduced to the extent that
the amount was not subject to tax because the S corporation had an excess
of recognized built-in loss over recognized built-in gain in the tax year of
the sale and succeeding tax years in the recognition period.
4. If income is reported under the installment method by an S corporation for
a tax year after the recognition period and the income is subject to tax
under the installment rule, in determining the built-in gain tax, the S
corporation’s Section 1374 attributes may be used to the extent their use is
otherwise allowed under the Code. The corporation’s loss recognized for
a tax year after the recognition period that would have been recognized
built-in loss if it had been recognized in the recognition period, however,
may not be used in determining the built-in gain tax imposed under
Section 1374.
I. Interests in Partnerships.
1. The IRS adopted a “look-through” approach with respect to an S corpora-
tion’s interest in a partnership. Consequently, an S corporation’s distribu-
tive share of a partnership’s items is treated as recognized built-in gain or
loss to the same extent that the S corporation would have been treated as
having recognized built-in gain or loss had the items originated in, and
been taken into account by, the S corporation itself.
2. Specifically, Treas. Reg. § 1.1374-4(i)(1) provides that if an S corporation
owns a partnership interest at the beginning of the recognition period or
transfers property to a partnership in a transaction to which Section
1374(d)(6) applies during the recognition period (where the basis of the
property received by the S corporation is determined in whole or in part by
reference to the basis of the property transferred by the S corporation), the
S corporation must determine the effect on its net recognized built-in gain
from its distributive share of partnership items in a four-step process: (1)
the S corporation applies the rules of Section 1374(d) to the S
corporation’s distributive share of partnership items of income, gain, loss
or deduction to determine the extent to which the partnership item would
have been treated as a recognized built-in gain or loss if such partnership
item had originated in, and been taken into account by, the S corporation
(“partnership 1374 items”); (2) the S corporation determines its net
recognized built-in gain without partnership 1374 items; (3) the S corpora-
tion determines its net recognized built-in gain with partnership 1374
items; and (4) if the amount of the S corporation’s net recognized built-in
gain determined with partnership 1374 items exceeds the S corporation’s
41
net recognized built-in gain determined without partnership 1374 items,
such excess is classified as the S corporation’s “Partnership RBIG”, and
the S corporation’s net recognized built-in gain is equal to the sum of its
recognized built-in gains determined without partnership 1374 items plus
its Partnership RBIG. If the S corporation’s net recognized built-in gain
determined without partnership 1374 items exceeds the S corporation’s net
recognized built-in gain determined with partnership 1374 items, such
excess is classified as the S corporation’s “Partnership RBIL”, and the S
corporation’s net recognized built-in gain is equal to the difference
between the amount of its net recognized built-in gain determined without
partnership items less its Partnership RBIL.
3. Under Treas. Reg. § 1.1374-4(i)(2), however, an S corporation’s
Partnership RBIG for any tax year may not exceed the excess (if any) of
the S corporation’s “RBIG limitation” over its Partnership RBIG for prior
tax years (unless the S corporation forms or avails itself of a partnership
with a principal purpose of avoiding the built-in gain tax), and an S
corporation’s Partnership RBIL for any tax year may not exceed the
excess (if any) of the S corporation’s “RBIL limitation” over its
Partnership RBIL for prior tax years. Under Treas. Reg. § 1.1374-4(i)(4),
an S corporation’s “RBIG limitation” or “RBIL limitation” is an amount
equal to: (1) the amount realized if on the first day of the recognition
period the S corporation sold its partnership interest at fair market value to
an unrelated party; decreased by (2) the corporation’s adjusted basis in the
partnership interest; and increased or decreased by (3) the corporation’s
allocable share of the partnership’s Section 481(a) adjustments. If the
result is a positive amount, the S corporation has a RBIG limitation, and if
the result is a negative amount, the S corporation has a RBIL limitation.
Consequently, the total amount of built-in gain which may be recognized
by an S corporation by application of the look-through rules is generally
limited to the excess of the fair market value of the S corporation’s
partnership interest on the first day of the recognition period over the S
corporation’s adjusted basis in such partnership interest on the first day of
the recognition period.
4. Additionally, under Treas. Reg. § 1.1374-4(i)(3), if an S corporation
disposes of its partnership interest, the amount which may be treated as
recognized built-in gain may not exceed the excess (if any) of the S
corporation’s RBIG limitation over its partnership RBIG during the
recognition period, and the amount which may be treated as recognized
built-in loss may not exceed the excess (if any) of the S corporation’s
RBIL limitation over its Partnership RBIL during the recognition period.
In other words, if an S corporation disposes of its partnership interest, the
amount treated as recognized built-in gain or loss on the disposition may
not exceed the difference between the fair market value of the S
corporation’s partnership interest and the S corporation’s adjusted basis in
such partnership interest as of the first day of the recognition period, less
42
any amounts previously treated as recognized built-in gain or loss to the S
corporation under the look-through rules.
5. Treas. Reg. § 1.1374-4(i)(5) provides that the look-through rules do not
apply to a tax year in the recognition period if the S corporation’s
partnership interest represents less than 10% of the partnership capital and
profits at all times during the tax year and prior tax years in the
recognition period, and the fair market value of the S corporation’s
partnership interest as of the beginning of the recognition period is less
than $100,000. If, however, the S corporation contributes any assets to the
partnership during the recognition period and the S corporation held the
assets as of the beginning of the recognition period, the fair market value
of the S corporation’s partnership interest as of the beginning of the
recognition period is determined as if the assets were contributed to the
partnership before the beginning of the recognition period. The exception
to the look-through rules for small partnership interests does not apply,
however, if a corporation forms, or avails itself of, a partnership with a
principal purpose of avoiding the tax imposed under Section 1374.
6. Treas. Reg. § 1.1374-4(i)(6) provides that for purposes of Section 1374
only, an S corporation’s Section 704(c) gain or loss amount with respect to
any asset is not reduced during the recognition period except for amounts
treated as recognized built-in gain or loss with respect to such asset under
the regulations.
7. Treas. Reg. § 1.1374-4(i)(7) provides that if on the first day of the
recognition period an S corporation holds an interest in a partnership
which holds an asset and during the recognition period the partnership
distributes such asset to the S corporation which thereafter disposes of
such asset, the asset is treated as having been held by the S corporation on
the first day of the recognition period and as having the same fair market
value and adjusted basis in the hands of the S corporation as such asset
had in the hands of the partnership on such day.
J. Inventory Items.
1. Inventory items are subject to the built-in gain tax to the extent the fair
market value of such items exceeds the corporation’s basis in such assets
as of the date of conversion to S status. Treas. Reg. § 1.1374-7(a)
provides that for purposes of the built-in gain tax, the fair market value of
the inventory of an S corporation on the first day of the recognition period
is equal to the amount that a willing buyer would pay a willing seller for
the inventory in a purchase of all of the S corporation’s assets by a buyer
that expects to continue to operate the S corporation’s business. The
buyer and seller are presumed not to be under any compulsion to buy or
sell and to have reasonable knowledge of all relevant facts, including: (1)
the replacement cost of the inventory; (2) the expected retail selling price
43
of the inventory; (3) the seller’s incentive to demand a price for the
inventory that would compensate for and provide a fair return for
expenditures the seller incurred to obtain, prepare, carry, and dispose of
the inventory before the sale of the business; and (4) the buyer’s incentive
to pay a price for the inventory that would compensate for and provide a
fair return for similar expenditures the buyer expects to incur after the sale
of the business.
2. Treas. Reg. § 1.1374-7(b) provides that the inventory method used by an S
corporation for tax purposes must be used to identify whether inventory
disposed of during the recognition period is inventory it held on the first
day of such period. Consequently, a corporation using the LIFO method
does not dispose of inventory it held on the first day of the recognition
period unless the carrying value of its inventory for a tax year during such
period is less than the carrying value of its inventory on the first day of the
recognition period. If a corporation changes its method of accounting
(from the FIFO method to the LIFO method or from the LIFO method to
the FIFO method) with a principal purpose of avoiding the tax imposed
under Section 1374, however, such corporation must use its former
inventory method to identify its dispositions of inventory.
K. After-Acquired Assets.
1. Under Section 1374(d)(6), where an asset having a built-in gain or loss on
the first day of S corporation status is exchanged for another asset in a
transaction in which the new asset’s basis is determined in whole or in part
by reference to the basis of the old asset (such as in a like-kind exchange
under Section 1031), the new asset will be treated as being held on the
first day of S status and as having the same built-in gain or loss as did the
old asset. The new asset will therefore be subject to the built-in gain tax to
the same extent as the old asset.
2. Furthermore, Section 1374(d)(8) and Treas. Reg. § 1.1374-8(a) provide
that if an S corporation acquires any asset in a transaction in which the S
corporation’s basis in the acquired asset is determined in whole or in part
by reference to a C corporation’s basis in such asset, Section 1374 applies
to the net recognized built-in gain attributable to the asset so acquired.
3. Treas. Reg. § 1.1374-8(b) provides that for purposes of applying the built-
in gain tax under Section 1374(d)(8), a separate determination of tax is
made with respect to the assets the S corporation acquires in one Section
1374(d)(8) transaction from the assets the S corporation acquires in
another Section 1374(d)(8) transaction and from the assets the corporation
held when it became an S corporation. Thus, an S corporation’s Section
1374 attributes when it became an S corporation may only be used to
reduce the built-in gain tax imposed on dispositions of assets the S
corporation held at that time. Likewise, an S corporation’s Section 1374
44
attributes acquired in a Section 1374(d)(8) transaction may only be used to
reduce the built-in gain tax imposed on dispositions of assets the S
corporation acquired in such transaction.
4. Treas. Reg. § 1.1374-8(c) provides that an S corporation’s taxable income
limitation for any tax year is allocated between or among each of the S
corporation’s separate determinations of net recognized built-in gain for
that year (determined without regard to the taxable income limitation)
based on the ratio of each such net recognized built-in gain amount to the
sum of all of the S corporation’s net recognized built-in gain amounts.
5. Consequently, every asset acquisition from a C corporation (or from an S
corporation subject to the built-in gain tax) will be subject to a separate
determination as to the amount of net unrealized built-in gain and net
recognized built-in gain, as well as to a separate 10-year recognition
period beginning with the date the S corporation acquires such assets from
the C corporation (or from the S corporation subject to the built-in gain
tax). This rule applies to all S corporation, regardless of when their S
elections were made or whether such corporations have always been S
corporations.
L. Anti-Stuffing Rule. Treas. Reg. § 1.1374-9 provides that if a corporation
acquires an asset prior to or during the recognition period with “a principal
purpose” of avoiding the tax imposed under Section 1374, the asset and any loss,
deduction, loss carryforward, credit and credit carryforward attributable to such
asset will be disregarded in determining the S corporation’s pre-limitation
amount, taxable income limitation, NUBIG limitation, deductions against net
recognized built-in gain and credits against the built-in gain tax. This rule is
primarily aimed at preventing shareholders from contributing assets having built-
in losses to the corporation immediately prior to electing S status in order to avoid
the built-in gain tax.
M. Pre-Conversion Planning Opportunities.
1. Early Election. Once a corporation has made the decision to convert
from C corporation status to S corporation status, it should make its S
election as soon as possible since only pre-conversion asset appreciation,
and not post-conversion asset appreciation, is subject to the built-in gain
tax. Additionally, the sooner the election is made, the sooner the 10-year
recognition period during which the built-in gain tax is in effect will lapse.
An “early” election is crucial not only for an existing C corporation con-
verting to S corporation status, but also for a sole proprietorship, partner-
ship or other unincorporated business which is incorporating. In such
cases, it is essential that the unincorporated business file its S election
effective for its first taxable year so that it can completely escape applica-
tion of the built-in gain tax (except with respect to any assets which it may
45
subsequently acquire from C corporations). If the newly formed
corporation fails to elect S corporation status for its first taxable year and
later converts to S corporation status, such corporation will be fully
subject to the built-in gain tax because of its C corporation history, even if
it was a C corporation for only one taxable year. The failure of an
unincorporated business to elect S corporation status for its first taxable
year as a corporation is particularly detrimental because not only will pre-
conversion corporate appreciation in its assets be subject to the built-in
gain tax, but also any pre-incorporation appreciation in its assets will be
subject to the built-in gain tax.
2. Deferral of Disposition of Loss Assets. Where a C corporation
contemplating conversion to S corporation status has built-in loss assets
which it intends to dispose of in the near future, such corporation should
defer the disposition of such built-in loss assets until after it has converted
to S corporation status in order to minimize the impact of the built-in gain
tax. By not disposing of such built-in loss assets prior to converting to S
corporation status, the built-in losses in these assets will reduce the overall
net unrealized built-in gain limitation and will also (when disposed of by
the corporation) offset recognized built-in gain and reduce the
corporation’s taxable income. Since built-in deduction items (such as
accounts payable of a cash basis corporation) are treated as built-in losses
for the taxable year in which such amounts are deducted by the
corporation, a C corporation contemplating conversion to S corporation
status should also defer the deduction of such items until after its
conversion to S corporation status.
3. Pre-conversion Transfer of Loss Assets to Corporation. Another pre-
conversion technique which may be utilized in limited circumstances to
reduce the effect of the built-in gain tax involves the pre-conversion
transfer, under Section 351 or Section 118, of built-in loss assets to the
converting corporation. However, this particular method of minimizing
the built-in gain tax must be used with great caution, since the anti-
stuffing rule set forth in Treas. Reg. § 1.1374-9 may apply to the
contributed loss assets. A corporation may receive the benefit of built-in
loss assets contributed to it prior to its conversion to S corporation status if
such corporation can demonstrate a “clear and substantial relationship”
between the contributed property and the corporation’s business. As such,
the pre-conversion contribution of built-in loss assets to a corporation
should be considered by the tax practitioner as one method of minimizing
the built-in gain tax under appropriate circumstances.
4. Accounts Receivable Planning Opportunities.
a. General. Because the accounts receivable of a cash-basis
corporation are included in determining a corporation’s NUBIG,
and the collection of such receivables is treated as a recognized
46
built-in gain under Section 1374, the cash-basis corporation, and
particularly the cash-basis service corporation, is potentially
subject to a substantial tax liability under Section 1374.
Consequently, it is imperative that the cash-basis service
corporation converting from C corporation status to S corporation
status consider all available planning opportunities to minimize the
impact of the built-in gain tax with respect to its accounts
receivable.
b. Zeroing Out of Taxable Income. Since the base of the built-in gain
tax is limited to a corporation’s taxable income, one method of
avoiding the built-in gain tax would be to zero out the
corporation’s taxable income for the entire 10-year built-in gain
period. Such a strategy seems inadvisable in that it could very well
subject the S corporation to the same unreasonable compensation
arguments to which it would have been subject had it remained a C
corporation. An S corporation would be susceptible to an
unreasonable compensation argument in this context since the
result of recharacterizing amounts paid as compensation to the
shareholder-physicians as distributions would be to increase the
corporation’s taxable income above zero, and thus, subject it to the
built-in gain tax.
c. Bonus Accrual Method. Due to the pass-through nature of an S
corporation, the collection of accounts receivable by a cash-basis
corporation that has converted from C corporation status to S
corporation status, absent proper planning, will result in a forced
double taxation on such receivables. One common method of
avoiding the built-in-gain tax on the accounts receivable of a cash
basis taxpayer is to accrue bonuses (in an amount equal to its
receivables) to its shareholder-employees in its last tax year as a C
corporation and pay such bonuses to its shareholder-employees in
its first tax year as an S corporation. Although there are a number
of open issues with regard to this strategy, PLR 200925005
confirms that this strategy does work.
(1) In PLR 200925005, the IRS ruled that the payment of
certain salary expenses and other outstanding costs relating
to the production of the outstanding accounts receivable of
the corporation at the time of its conversion to S status
would constitute built-in deduction items, specifically
including the payment of compensation to shareholder-
employees of the corporation within the first two and one-
half months following the corporation’s conversion to S
corporation status.
(2) Under the facts of the ruling, the taxpayer is a cash basis C
47
corporation with a calendar tax year. The corporation is a
personal service corporation which is wholly-owned by a
number of professionals. The corporation bills its clients
for the services performed by the professionals and when
invoices are paid, the corporation pays salaries and wages
to the professionals. Additionally, the corporation has
other employees, such as non-shareholder clerical staff and
non-shareholder professionals to which it pays wages.
(3) The taxpayer will elect to be an S corporation and will have
built-in gain from its outstanding accounts receivable. The
taxpayer requested the letter ruling to determine whether
certain salary expenses and other outstanding costs relating
to the production of the outstanding accounts receivable as
of the date of the corporation’s conversion to S status will
qualify as built-in losses under Section 1374, and
specifically, whether the amounts paid to its shareholder-
employees within the first two and one-half months of the
recognition period under Section 1374 of salary and wage
expenses that are related to the production of accounts
receivable that are outstanding as of the effective date of
the S election will constitute built-in deduction items under
Section 1374(d)(5)(B).
(4) The post-conversion collection of accounts receivable of a
cash-basis corporation, particularly the cash-basis service
corporation, is potentially subject to a substantial tax
liability for the built-in gain tax imposed under Section
1374. Due to the pass-through nature of an S corporation,
the collection of accounts receivable by a cash-basis
corporation that has converted from C corporation status to
S corporation status, absent proper planning, will result in a
forced double taxation on such receivables of
approximately 57.75%.2 Consequently, it is imperative that
the cash-basis service corporation converting from C
corporation status to S corporation status consider all
available planning opportunities to minimize the impact of
the built-in gain tax with respect to its accounts receivable.
(5) Since built-in deduction items (such as accounts payable of
cash-basis corporations) are taken into account in
2 Assuming $100 of accounts receivable, the built-in gain tax would be $35 ($100 x 35%), and the
shareholder-level tax (assuming the maximum marginal individual tax rate of 35%) would be $22.75 ($65
x 35%). Thus, total taxes on the $100 of accounts receivable would be $57.75 ($35 + $22.75), resulting
in an effective federal tax rate of 57.75%. In addition, state corporate income taxes may be imposed on
the corporate level gain.
48
determining NUBIG of an S corporation under Section
1374(d)(5)(C), and the payment of such amounts is treated
as a recognized built-in loss that may be matched against
built-in income items (such as a cash-basis corporation’s
accounts receivable), a common method that has been
employed by practitioners to avoid the built-in gain tax
imposed on the accounts receivable of a cash basis service
corporation is to accrue bonuses (in an amount equal to its
collectible receivables) to its shareholder-employees in its
last tax year as a C corporation and pay such bonuses to its
shareholder-employees in its first tax year as an S
corporation. Even though such accrued bonuses may or
may not be characterized as built-in deduction items
(depending on whether they are paid in the first two and
one-half months following conversion), the effect of
accruing such bonuses nevertheless may be either to
eliminate the potential application of the built-in gain tax
altogether by reducing the corporation’s NUBIG to zero, or
alternatively, if the corporation has goodwill or other
appreciated assets, to at least minimize recognition of any
built-in gain by reducing the corporation’s NUBIG by the
amount of such accrued bonuses. There are a number of
open issues regarding the mechanics of accruing such
bonuses. These open issues include:
(a) whether such bonuses should be paid within the first
two and one-half months so as to constitute built-in
deduction items that offset the built-in income items
(receivables), or whether such bonuses may be paid
at any time during the corporation’s first taxable
year as an S corporation based on the position that
the accrued bonuses reduce the corporation’s
NUBIG to zero;
(b) if the corporation intends to pay such bonuses in
cash within the first two and one-half months and
funds must be borrowed to pay such bonuses,
whether the corporation or the shareholder-
employees should borrow such funds;
(c) whether such bonuses could be paid by simply
having the corporation distribute the accounts
receivable attributable to the accrued bonuses
within the first two and one-half months following
conversion to S corporation status (as opposed to
paying such bonuses out in cash);
49
(d) whether the regular salaries of the shareholder-
employees should be “suspended” in order to enable
the corporation to pay such bonuses;
(e) assessment of the effect of such bonuses on any
buy-out provision in the event a shareholder-
employee’s employment is terminated after receipt
of the bonus but prior to any loans funding such
bonus being repaid;
(f) whether the employment agreements of the
shareholder-employees should be amended to
provide compensation for nonbillable services to
support compensation paid in “C” years as well as
accrual of the bonus;
(g) documentation of such accrued bonuses in the
minutes of the board of directors as compensation
for past services; and
(h) whether the corporation should continue zeroing out
its taxable income for some period of time in order
to support compensation amounts paid in prior “C”
years as well as to provide a “back-up” for the
bonus accrual strategy.
(6) Although PLR 200925005 certainly does not answer all of
these open questions, it certainly makes it clear that the
built-in gain tax on accounts receivable can be avoided by
the converted corporation paying out compensation related
to such accounts receivable to its shareholder-employees
within the first two and one-half months of the
corporation’s first tax year as an S corporation, which is the
method that has been most commonly employed by
practitioners in order to avoid imposition of the built-in
gain tax on the accounts receivable of a cash basis service
corporation.
(7) The IRS expressly concludes in the ruling that the
taxpayer’s payments to its shareholder-employee of salary
and wages relating to the production of accounts receivable
on the effective date of the S election, if paid in the first
two and one-half months of the recognition period,
qualify as built-in loss items under Section 1374(d)(5)(B).
Additionally, the IRS found that the taxpayer’s payments to
its non-shareholder employees of salary and wages related
to the production of outstanding accounts receivable on the
50
effective date of the S election, if paid at any time during
the recognition period, will qualify as built-in loss items
under Section 1374(d)(5)(B). Finally, the IRS concluded
that the taxpayer’s payments of other unpaid payable
expenses and accounts payable related to the production of
the accounts receivable outstanding on the effective date of
the S election, if paid at any time during the recognition
period, would qualify as built-in loss items under Section
1374(d)(5)(B).
(8) It is interesting to note that PLR 200925005 did not
specifically state that any type of special bonus had to be
accrued prior to the last day of the corporation’s last tax
year as a C corporation or require any written evidence of
such accrual in the corporate minutes or other
documentation. Rather, the IRS simply concluded that the
payment of salary and wages to the shareholder-employees
of the corporation which related to the production of the
accounts receivable on the effective date of the S election
would qualify as built-in loss items if paid in the first two
and one-half months of the recognition period. To be
certain, the author would recommend that such bonus be
accrued prior to the last tax year as a C corporation and
evidenced at least in the Board of Director minutes of the
corporation.
d. Acceleration of Accounts Receivable. Alternatively, in order to
avoid forced double taxation on its receivables, a service
corporation converting from C to S corporation status may choose
to accelerate its receivables income and recognize such income
prior to conversion to S corporation status. In this manner, the
corporation may be able to defer (possibly indefinitely)
shareholder-level tax on its receivables until the earnings and
profits generated by the collection of such receivables are
distributed to the corporation’s shareholders. The recognition of
receivables income by a corporation prior to its conversion to S
corporation status will have the added benefit of decreasing its
overall NUBIG. The pre-conversion recognition of receivables
income may be achieved in at least three ways.
(1) First, the corporation may simply assign and sell its
accounts receivable prior to its conversion to S corporation
status to a third party.
(2) Second, the corporation may sell its accounts receivable to
its shareholder-employees prior to its conversion to S
corporation status. Additionally, in each of the first two
51
alternatives, the sale of the receivables could be combined
with the payment of a bonus in an amount equal to the sales
proceeds in order to avoid payment of a corporate level tax
on the corporation’s sale of its receivables.
(3) Finally, the corporation could, in order to avoid a pre-
conversion C corporation tax on the sale of its accounts
receivable, simply “bonus” its accounts receivable to its
shareholder-employees. The pre-conversion recognition of
receivables income by a service corporation, when
combined with the payment of a corresponding bonus to its
shareholder-employees, should also limit any attempts by
the IRS to recharacterize payments to the corporation’s
shareholder-employees as dividend distributions under
unreasonable compensation arguments to the corporation’s
last tax year as a C corporation.
5. Examples. The examples set forth below examine tax planning
alternatives available with respect to the accounts receivable of a cash-
basis service corporation converting to S corporation status. Note that
these examples all utilize the tax rates in effect under the Bush tax cuts
through 2010. The results will be even more dramatic if the Bush tax cuts
are not extended by legislative action for 2013 and subsequent years.
a. Example 1. No Planning. Doctors R Us, a professional
corporation using the cash receipts and disbursements method of
accounting, has taxable income (pre-salary and bonus to its four
shareholder-employees) of $1,000,000. The corporation is
planning to pay total salaries and bonuses to its four shareholder-
employees of $1,000,000, resulting in taxable income to the
corporation of zero. The corporation also has $200,000 of
accounts receivable as of December 31, 2008, which will be
collected and give rise to income in 2009. The corporation desires
to elect S corporation status effective January 1, 2009. If the
corporation takes no action to affirmatively plan for its receivables
and has no other built-in gain or built-in loss items, it potentially
will be subject to a tax of $70,000 under Section 1374 on the
collection of the $200,000 of receivables in 2009 (35% of
$200,000). The $200,000 of income recognized on the collection
of the receivables, reduced under Section 1366(f)(2) by the
$70,000 corporate level tax imposed under Section 1374, will pass
through to, and be taken into account by, the individual
shareholder-employees of the corporation under Section 1366 in
2009. Consequently, assuming a maximum marginal tax rate of
35% for individuals, the shareholder-employees will be subject to a
tax of $45,500 (35% of $130,000). The aggregate tax paid by both
the corporation and the individual shareholders of the corporation
52
on the $200,000 of receivables will therefore be $115,500 ($70,000
corporate level tax under Section 1374 plus $45,500 tax imposed
on the individual shareholder-employees), resulting in an aggregate
tax rate of approximately 57.75% (ignoring the phase out of
itemized deductions and personal exemptions, employment taxes
and any state and local taxes).
b. Example 2. Accrual of Bonus. Now assume that the corporation
accrues an additional bonus to its four shareholder-employees in
2008 of $200,000, an amount equal to its receivables. Under
Section 1374(d)(1), the corporation should avoid application of the
built-in gain tax altogether because its NUBIG will be zero (even if
the accrued bonus does not constitute a built-in deduction item
under Section 1374(d)(5) because of the limitations of Section
267(a)(2) and/or Section 404(a)(5)). As such, when the
receivables are collected by the corporation in 2009, they will be
subject to a single level of tax at the shareholder level of $70,000
(35% of $200,000). If the accrued bonus is paid within the first
two-and one-half (2-1/2) months of the corporation’s first taxable
year as an S corporation, it will constitute a built-in deduction item
that will offset the built-in income item dollar for dollar, again
resulting in a single level of tax at the shareholder level of $70,000.
This same result should also occur if the accounts receivable
themselves (rather than cash) are bonused out to the shareholder-
employees in 2009.
If, however, the accrual of the bonus in 2008 is somehow
determined to be without substance (and assuming that the
$200,000 paid to the shareholder-employees is treated as a
distribution so that the taxable income of the corporation is not
reduced to zero in 2009), the tax effect will be the same as in
Example 1 above where there was no tax planning: a corporate
level tax will be imposed on the S corporation under Section 1374
in an amount equal to $70,000, and the balance of the $200,000
will pass through to the individual shareholders of the corporation
and be taxed at 35%, resulting in a total tax of $115,500 and an
aggregate effective tax rate of approximately 57.75%.
c. Example 3. Sale of Receivables to Third Party. Now assume that
instead of accruing a bonus in 2008, the corporation sells the
receivables to a third party (for their face value). Also assume that
the corporation continues its policy of reducing its taxable income
to zero except for the $200,000 recognized on the sale of its
receivables. In this situation, the corporation (assuming that it is a
qualified personal service corporation within the meaning of
Section 448(d)(2) which is subject to the flat 35% tax rate), will be
subject to a tax of $70,000 on the sale of its receivables to the third
53
party (35% of $200,000). In turn, the earnings and profits of the
corporation will be increased by $130,000, the difference between
the $200,000 received on the sale of the receivables and the
$70,000 of taxes paid with respect to the sale of the receivables.
The shareholder-employees will not, however, be taxed on the
$130,000 of earnings and profits until such earnings and profits are
distributed to them.
Although the corporate level tax of $70,000 is accelerated and
recognized in 2008 rather than in 2009, any tax payable at the
shareholder level may be deferred for a number of years and, in
fact, may never be recognized by the shareholders if the
distributions made by the corporation never exceed its accumulated
adjustments account following its conversion to S corporation
status.
d. Example 4. Sale of Receivables to Third Party and Payment of
Bonus. Assume the same facts as in Example 3 except that in
addition to selling the receivables to a third party, the corporation
distributes the additional $200,000 collected on the sale of its
receivables to its four shareholder-employees as an additional
bonus, thus reducing the corporation’s taxable income to zero. The
corporation will not be subject to the built-in gain tax imposed
under Section 1374 since it will no longer own any receivables,
and additionally will not be subject to any tax in 2008 since it will
have no taxable income. The shareholders will be subject,
however, to a tax of $70,000 in 2008, determined by multiplying
the additional $200,000 bonus by the highest marginal individual
income tax rate of 35%.
The sole difference between this example and the straight accrual
of a bonus alternative found in Example 2 is that the tax of $70,000
is paid in 2008 in this case whereas the tax of $70,000 is paid in
2009 in the case of a bonus accrued in 2008. This method has an
additional advantage of not exposing the corporation to an
unreasonable compensation argument beyond its last tax year as a
C corporation since it will not be subject to Section 1374, and as
such, will have no reason to pay high amounts of compensation to
its shareholder-employees in order to zero out its income.
In the event the IRS successfully recharacterizes the additional
$200,000 bonus paid in 2008 as a dividend distribution under an
unreasonable compensation argument, however, the corporation
will be subject to a corporate level tax on the $200,000 collected in
2008 of $70,000 (35% of $200,000), and the individual
shareholders will additionally be subject to a shareholder level tax
(assuming sufficient earnings and profits) of either: (i) $30,000
54
(15% of $200,000), resulting in an aggregate tax liability of
$100,000, or an effective aggregate (corporate and individual) tax
rate on the collection of the receivables of 50%; or (ii) $19,500
(15% of $130,000), resulting in an aggregate tax liability of
$89,500, or an effective aggregate (corporate and individual) tax
rate on the collection of the receivables of 44.75%.
Obviously, the tax practitioner should be confident that the
additional bonus will not be recharacterized as a dividend before
advising use of this alternative because of the adverse tax
consequences if unsuccessful.
e. Example 5. Sale of Receivables to Shareholder-Employees.
Assume the same facts as in Example 4 except that the corporation
sells the receivables to its shareholder-employees for $200,000.
Assuming that the shareholder-employees have $200,000 to pay
the corporation for the receivables (or will execute promissory
notes to the corporation for the receivables), the corporation will
recognize a corporate level tax of $70,000 in 2008.
As the shareholder-employees collect the receivables in 2009, they
will recognize no gain since they will have a cost basis in the
receivables under Section 1012 equal to $200,000. Again, until
some future point in time when the earnings and profits of
$130,000 ($200,000 of sales proceeds minus $70,000 of tax) is
distributed to such shareholder-employees, any shareholder level
tax will be deferred. This is the same result as achieved in
Example 3, where the receivables were sold to a third party. Since
it may be impossible for a corporation to find a third party willing
to buy its receivables, it may be forced to sell the receivables to its
shareholders if it desires to dispose of its receivables prior to its
conversion to S corporation status.
f. Example 6. Sale of Receivables to Shareholder-Employees and
Payment of Bonus. Assume the same facts as in Example 5 where
the corporation sold the receivables to its shareholder-employees,
but assume as in Example 4 that the corporation accrues an
additional bonus of $200,000 to its shareholder-employees. In
actuality, the only money that will change hands on the sale of the
receivables will be withholding taxes since the shareholders will be
receiving a bonus equal to the amount which they are paying for
the receivables of the corporation (less applicable withholding
taxes).
Just as in Example 4, if this strategy is successful, the receivables
will be subject to a single level of tax at the shareholder level equal
to $70,000 (35% of $200,000) in 2008. As the receivables are
55
collected by the shareholders in 2009, they will recognize no
income since they will have a cost basis in the receivables under
Section 1012 of $200,000. In the event that the additional bonus of
$200,000 is recharacterized as a dividend distribution in the
corporation’s last tax year as a C corporation under an
unreasonable compensation argument, it will face a corporate level
tax of either (i) $70,000 (35% of $200,000) and the shareholders
will face an additional shareholder level tax of $30,000 (15% of
$200,000), for a total tax of $100,000 and an effective aggregate
tax rate of 50%; or (ii) $19,500 (15% of $130,000), resulting in an
aggregate tax liability of $89,500, or an effective aggregate
(corporate and individual) tax rate on the collection of the
receivables of 44.75%. Once again, the tax practitioner should
make the corporation aware of this risk and be confident that the
additional bonus to be paid to the shareholder-employees will not
be recharacterized as a dividend.
g. Example 7. Bonus of Receivables. Assume the same facts as in
Example 6 except that the corporation simply distributes the
$200,000 of receivables proportionately to the shareholder-
employees generating the receivables as a bonus. Under the
assignment of income doctrine, the corporation should recognize
$200,000 of income on the distribution of its receivables to its
shareholder-employees, but will receive a corresponding
compensation deduction for the $200,000 bonus paid to them. The
shareholders will therefore recognize $200,000 of income in 2008,
and be subject to a tax of $70,000 (35% of $200,000).
Once again, the shareholder-employees will have a Section 1012
tax-cost basis in the receivables, and as such, will recognize no
income in 2009 when they collect the receivables. In the event,
however, that the additional bonus is deemed to be unreasonable
compensation and recharacterized as a dividend distribution, the
aggregate tax imposed upon the receivables will be the same as in
Examples 4 and 6.
6. Summary of Accounts Receivable Planning Alternatives.
a. These examples demonstrate that the accrual of a bonus in an
amount equal to the receivables of a cash-basis service corporation
in its final C year, produces the lowest amount of tax and the
greatest amount of deferral on the entire amount of tax due
(provided the corporation has no other built-in gain items).
Alternatively, the sale of the corporation’s receivables prior to its
conversion to S corporation status will accelerate the corporate
level tax due on the receivables, but may result in an indefinite
deferral of the shareholder level tax on the earnings and profits
56
generated by the sale of the receivables. The sale of receivables in
a cash-basis service corporation’s last C year with a corresponding
bonus in the amount of its receivables or the bonus of its
receivables will result in a single level of tax and a one year
acceleration of income in comparison to the bonus accrual
alternative. The alternatives involving the sale or bonus of the
cash-basis service corporation’s receivables in its last C year also
have the added benefit of limiting any unreasonable compensation
arguments to its last year as a C corporation, rather than exposing
the corporation to such an argument in years following its
conversion to S corporation status when the corporation may be
subject to the built-in gain tax imposed under Section 1374.
b. Consequently, the tax practitioner must analyze the specific facts
and circumstances of each situation, including the total
compensation package otherwise being paid to the shareholder-
employees of the corporation in its last year as a C corporation, in
order to determine the optimal planning alternative regarding the
cash-basis service corporation’s receivables. In no event, however,
should the cash-basis service corporation merely convert to S
corporation status without engaging in any planning to minimize
the built-in gain tax which will be imposed under Section 1374 on
such corporation’s receivables.
7. Appraisal of Assets. Where a converting corporation can establish either
that the particular asset disposed of was not held by the corporation as of
the effective date of its conversion from C corporation status to S
corporation status, or that such asset’s built-in gain as of the date of the
corporation’s conversion from C corporation status to S corporation status
was less than the gain recognized by the corporation on such disposition,
the amount of the corporation’s recognized built-in gain will be reduced
accordingly. The built-in gain tax is thus limited to the amount of the
converting corporation’s pre-conversion appreciation in its assets, and as
such, it is essential that the converting corporation have each of its assets
identified and appraised as of the effective date of its conversion from C
corporation status to S corporation status.
N. Post Conversion Planning Opportunities. In addition to the pre-conversion
planning opportunities discussed above, there are a variety of techniques which
may be used by the converting corporation to minimize or eliminate its built-in
gain tax following its conversion from C corporation status to S corporation
status. A number of these post-conversion planning opportunities are discussed
below.
1. Preservation of Pre-1987 and Pre-1989 Elections. Because the excess
capital gains tax imposed by Section 1374 prior to its amendment by
TRA'86 is generally less burdensome than the built-in gain tax imposed
57
under Section 1374, in most cases it will be beneficial for those C
corporations which filed S corporation elections prior to January 1, 1987,
to retain and preserve such elections so as not to become subject to the
built-in gain tax. Similarly, since the rules applicable to C corporations
converting to S corporation status during the transitional period and which
otherwise qualified for transitional rule relief are less burdensome than the
rules imposed under the built-in gain tax, corporations which made
transitional-period S elections should retain and preserve such elections so
as not to become subject to the built-in gain tax.
2. Preservation of Post-December 31, 1988 Elections. Though corpora-
tions filing S corporation elections after December 31, 1988 are fully
subject to the built-in gain tax, it will still be beneficial for such
corporations to preserve such elections in order to avoid the application of
a new 10-year recognition period which would result if such corporation’s
S election terminates and the corporation subsequently files a new S
election.
3. Matching of Built-In Losses with Built-In Gains. Under the
amendments made to the built-in gain tax by TAMRA, an S corporation is
allowed to use its recognized built-in losses to offset its built-in gains.
Thus, a corporation may minimize the impact of the built-in gain tax by
disposing of assets which have built-in losses during taxable years in
which it has disposed of assets having built-in gains. Similarly, a cash
basis corporation subject to the built-in gain tax should match built-in loss
items (such as accounts payable) with built-in gain items (such as accounts
receivable) recognized during the taxable year. Since corporations
electing S corporation status after March 31, 1988 must carryforward any
excess recognized built-in gains over built-in losses that are not subject to
the built-in gain tax due to the taxable income limitation, it will be even
more important for such corporations (as opposed to corporations making
S elections prior to March 31, 1988 which are not subject to the
carryforward rule) to reduce their recognized built-in gains by the
recognition of built-in losses to an amount which is less than the taxable
income of the corporation for the taxable year. In other words, if a
corporation which made an S corporation election after March 31, 1988
can make the base of the built-in gain tax the excess of recognized built-in
gains over recognized built-in losses rather than taxable income, such
corporation will be able to avoid application of the new carryforward rule
enacted by TAMRA.
4. Reduction of Taxable Income. Since the base of the built-in gain tax is
the lesser of the taxable income of the corporation or the amount which
would be its taxable income if only recognized built-in gains and
recognized built-in losses were taken into account, the corporation may
minimize or eliminate the imposition of the built-in gain tax for a given
taxable year by reducing or eliminating its taxable income. However, as
58
discussed above, for corporations making S elections after March 31,
1988, to the extent that the taxable income of the corporation is less than
the excess of the corporation’s recognized built-in gains over its
recognized built-in losses, such excess will be carried forward and treated
as built-in gain in the corporation’s succeeding taxable year.
Nevertheless, if the corporation can eliminate (or greatly minimize) its
taxable income during the entire 10-year recognition period (by means of
the payment of compensation to its shareholders or by some other
method), such corporation may be able to completely avoid imposition of
the built-in gain tax. For corporations which made S elections prior to
March 31, 1988, the reduction of taxable income is just as important as the
matching of recognized built-in losses with recognized built-in gains since
such corporations are not subject to the carryforward rule enacted by
TAMRA.
5. Net Operating Loss Carryforwards. Under Section 1374(b)(2), the base
of the built-in gain tax for a particular taxable year, whether it is the
excess of recognized built-in gains over recognized built-in losses or the
corporation’s taxable income, may be reduced by net operating loss carry-
forwards arising from years in which the corporation was a C corporation.
Likewise, capital loss carryforwards from C years are allowed to reduce
the base of the built-in gain tax. The tax computed under Section 1374
may also be reduced by business credit carryforwards from C years. Thus,
the tax practitioner should be aware of, and actively plan for the utilization
of, net operating loss carryforwards, capital loss carryforwards and
business credit carryovers, from C years.
6. Non-Recognition Transactions. Another post-conversion method of
minimizing the impact of the built-in gain tax is for the S corporation to
dispose of its built-in gain assets in non-recognition transactions, such as
in a Section 1031 like-kind exchange, a Section 1033 involuntary
conversion, a Section 351 incorporation transaction or a Section 361
reorganization transaction, so as to defer recognition of the built-in gain
inherent in its assets. Though the amendments made by TAMRA subject
any asset received by an S corporation in a non-recognition transaction
such as those discussed above to the built-in gain tax to the same extent as
the asset which was disposed of, the non-recognition transaction itself will
not trigger application of the built-in gain tax and may therefore be used as
a deferral device.
7. Deferral of Disposition of Assets. A corporation, if possible, should
simply avoid the disposition of assets having built-in gain during the 10-
year recognition period. Alternatively, where such dispositions are
unavoidable, disposition of assets having built-in losses should be matched
with the disposition of built-in gain assets, as discussed above, to
minimize the corporation’s built-in gain tax exposure.
59
IX. CHANGES IN FORM OF ENTITY NOT RESULTING IN CHANGE OF TAX
STATUS OF ENTITY
A. In General. Unlike the various transactions discussed above, an entity may
change its status for state law purposes but still be treated the same for federal tax
purposes. Some examples of such transactions include reorganizations under
Section 368(a)(1)(F) involving both C and S corporations, changes from one type
of tax partnership to another type of tax partnership and mergers involving
partnerships. Changes in form of entities treated as an “F” reorganization will be
briefly discussed below. This outline will not discuss the issues attendant to the
change from one type of tax partnership to another type of tax partnership and
mergers involving only partnerships.
B. F Reorganizations. Under Section 368(a)(1)(F), a tax-free reorganization
includes a mere change in identity, form, or place of organization of one
corporation, however effected. The most common example of an F
reorganization which results in a change in the form of state law entity but does
not change the federal income tax status of the entity is the conversion of a state
law corporation (whether taxed as a C or S corporation) pursuant to the applicable
state law formless conversion statute into an LLC which elects under the check-
the-box regulations to be treated as an association taxable as a corporation.
Although the entity has changed its state law form from a corporation to an LLC,
it will continue to be taxed as a corporation for federal income tax purposes, and
as such, no tax consequences result from such conversion. An F reorganization
may also occur where a corporation mergers under the applicable state law cross-
entity merger statute into an LLC which elects to be treated as an association
taxable as a corporation. In the case of S corporations, special attention must be
paid to whether a new S election must be made and what employer identification
number will be used for the new entity.
1. Rul. 64-250. Rev. Rul. 64-250, 1964-2 C.B. 333, provides that when an S
corporation merges into a newly formed corporation in a transaction
qualifying as a reorganization under Section 368(a)(1)(F) and the newly
formed surviving corporation also meets the requirements of an S
corporation, the reorganization does not terminate the S election, and as
such, the S election remains in effect for the new corporation (without the
new corporation being required to file a new S election).
2. Rev. Rul. 73-526. In Rev. Rul. 73-526, 1973-2 C.B. 404, the IRS
concluded that where an S corporation merged into another corporation in
a transaction qualifying as an F reorganization, the acquiring (surviving)
corporation should use the employer identification number of the
transferor corporation.
3. IRS Clarifies Treatment of S Elections and Employer Identification
Numbers in F Reorganizations. In Rev. Rul. 2008-18, the IRS ruled that
in the two situations presented in the rulings, which both qualified as F
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reorganizations within the meaning of Section 368(a)(1)(F), the S election
of the existing corporations did not terminate (and were carried over to the
newly formed corporations), but that the newly formed corporations would
be required to obtain new employer identification numbers.
a. In situation 1 of the ruling, B, an individual, owned all of the stock
of Y, an S corporation. In year 1, B forms Newco and contributes
all of the Y stock to Newco, which meets the requirements for
qualification as a small business corporation. Newco timely elects
to treat Y as a qualified subchapter S subsidiary (QSub) effective
immediately following the transaction. The ruling states that the
transaction meets the requirements of an F reorganization under
Section 368(a)(1)(F). In year 2, Newco sells 1% of the stock of Y
to D, an unrelated party.
b. In situation 2, C, an individual, owns all of the stock of Z, an S
corporation. In year 1, Z forms Newco, which in turn forms
Mergeco. Pursuant to a plan of reorganization, Mergeco merges
with and into Z, with Z surviving and C receiving solely Newco
stock in exchange for his stock of Z. Consequently, C owns 100%
of Newco, which in turn owns 100% of Z. Newco meets the
requirements for qualification as a small business corporation and
timely elects to treat Z as a QSub effective immediately following
the transaction. Again, the ruling expressly states that the
transaction meets the requirements of an F reorganization.
c. Rev. Rul. 2008-18 provides, however, that since the publication of
Rev. Rul. 73-526, the Code has been amended to provide the
classification of certain wholly-owned subsidiaries of S
corporations as QSubs and the regulations under Section 6109
have been amended to address the effect of QSub elections under
Section 1361. Specifically, Treas. Reg. § 301.6109-1(i)(1)
provides that any entity that has a federal employer identification
number will retain that employer identification number if a QSub
election is made for the entity under Treas. Reg. § 1.1361-3 or if a
QSub election that was in effect for the entity terminates under
Treas. Reg. § 1.1361-5. Additionally, Treas. Reg. § 301.6109-
1(i)(2) provides that, except as otherwise provided in regulations or
other published guidance, a QSub must use the parent S
corporation’s employer identification number.
d. Additionally, for tax years beginning after December 31, 2004,
Section 1361(b)(3)(E) was amended to provide that except to the
extent provided by the IRS, QSubs are not disregarded for
purposes of information returns. Further, QSubs are not
disregarded for certain other purposes as provided in the
regulations. For example, Treas. Reg. § 1.1361-4(a)(7) provides
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that a QSub is treated as a separate corporation for purposes of
employment tax and related employment requirements effective
for wages paid on or after January 1, 2009. Because a QSub is
treated as a separate corporation for certain federal tax purposes,
the QSub must retain and use its employer identification number
when it is treated as a separate corporation for federal tax purposes.
e. Because of these recent changes, the IRS concluded that it would
not be appropriate for the acquiring corporation in a reorganization
under Section 368(a)(1)(F) to use the employer identification
number of the transferor corporation that becomes a QSub. Thus,
in situation 1, although Y’s original S election will not terminate
but will continue for Newco, Newco will be required to obtain a
new employer identification number and Y will retain its employer
identification number even though a QSub election is made for it
and will be required to use its original employer identification
number anytime Y is otherwise treated as a separate entity for
federal tax purposes. Additionally, in year 2, when Newco sells
1% of the stock of Y to D, Y’s QSub election will terminate under
Section 1361(b)(3)(C) and Y will be required to use its original
employer identification number following the termination of its
QSub election.
f. Likewise, in situation 2, Z’s original S election will not terminate
as a result of the F reorganization but will continue for Newco, and
as such, Newco will not be required to file a new S election.
Again, however, Newco will be required to obtain a new employer
identification number and Z must retain its employer identification
number even though a QSub election is made for Z and must use
its original employer identification number any time it is otherwise
treated as a separate entity for federal tax purposes or if its QSub
election terminates.
g. Rev. Rul. 2008-18 applies to F reorganizations occurring on or
after January 1, 2009. For F reorganizations occurring on or after
March 7, 2008 and before the effective date of the ruling,
taxpayers may rely on Rev. Rul. 2008-18. The ruling
acknowledges that the IRS is aware that prior to the effective date
of the ruling, S corporations have undergone F reorganizations in a
manner similar to those described in situations 1 and 2 in which the
acquiring corporation continued to use the transferor corporation’s
employer identification number consistent with Rev. Rul. 73-526.
In those cases, the IRS provides that the acquiring corporation
should continue to follow Rev. Rul. 73-526 and use the transferor
corporation’s employer identification number and that after the F
reorganization, the transferor QSub should use the parent’s
employer identification number until such time as the QSub is
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otherwise treated as a separate corporation for federal tax purposes
or until such time as the QSub terminates. At such time, the QSub
must obtain a new employer identification number. The IRS also
states in the ruling that for an F reorganization occurring prior to
January 1, 2009, it may be prudent for the acquiring corporation to
make a protective S election.
h. Rev. Rul. 2008-18 is consistent with a number of prior rulings
issued by the IRS to the extent that the newly formed corporation
making a QSub election for the existing (transferor) corporation is
not required to make a new S election. On the other hand, Rev.
Rul. 2008-18 reverses the holdings in a number of prior rulings
which provided that the newly formed corporation should use the
employer identification number of the existing corporation (which
becomes a QSub). See, e.g., PLRs 200701017 and 200725012.
The ruling does state, however, that in situations not involving a
QSub, such as the specific situation set forth in Rev. Rul. 73-526
involving the merger of one S corporation with and into another
corporation that constitutes an F reorganization, the surviving
corporation in those circumstances would use the employer
identification of the transferor corporation.
4. IRS Applies Rev. Rul. 2008-18 to F Reorganization Involving
Qualified Subchapter S Subsidiary. In EEC 200941019 (Oct. 9, 2009),
the IRS issued email guidance to a taxpayer providing that the taxpayer
could rely on Rev. Rul. 2008-18, 2008-13, IRB 674.
a. In the email advice, C owns all of the stock of Z, an S corporation
with an existing employer identification number. In year 1, Z
forms NewCo, which in turn forms MergeCo. Pursuant to a plan
of reorganization, MergeCo merged with and into Z with Z
surviving and C receiving solely NewCo stock in exchange for Z
stock. NewCo meets the requirements for qualification as a small
business corporation and timely elects to treat Z as a QSub
effective immediately following the transaction.
b. The email advice provides that the taxpayer may rely on the
principles set forth in Rev. Rul. 2008-18, and consequently, Z’s
original S election will not terminate but will continue for NewCo,
but NewCo will be required to obtain a new employer
identification number and Z will retain its existing employer
identification number even though a QSub election is made for it.
Additionally, the IRS provided in the email advice that Z would
not file a final Form 1120S, but rather that NewCo would report all
of Z’s and NewCo’s income on its Form 1120S.
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5. Merger of Parent S Corporation into QSub Constitutes an F
Reorganization. In PLR 201007043, the IRS ruled that an S
corporation’s merger into its wholly owned qualified subchapter S
subsidiary (QSub) constituted a tax-free reorganization under Section
368(a)(1)(F) without adversely affecting S corporation status.
a. In the ruling, the S corporation and one of its two wholly owned
QSubs desired to combine their assets and operations into a single
corporation in order to take advantage of planned efficiencies and
to reduce expenses and redundancies. Because certain legal
agreements of the QSub prohibited the QSub from merging
upstream into the S corporation, it was decided that the S
corporation should merge downstream into the QSub.
b. Citing Rev. Rul. 64-250, 1964-2 C.B. 333, the IRS concluded that
pursuant to the F reorganization, the S corporation election would
continue in effect with respect to the surviving QSub following the
merger. Additionally, citing Rev. Rul. 2004-85, 2004-2 C.B. 189,
the IRS found that the status of the S corporation’s other QSub
would not terminate as a result of the F reorganization.
c. Interestingly, the ruling does not address whether the surviving
entity should continue to use the federal identification number
previously used by the S corporation or the federal identification
number of the QSub into which it was merged. In Rev. Rul. 73-
526, 1973-2 C.B. 404, the IRS ruled that where an S corporation
merges into another corporation in a transaction qualifying as an F
reorganization, the acquiring (surviving) corporation should use
the employer identification number of the transferor corporation.
However, more recently in Rev. Rul. 2008-18, 2008-1 C.B. 674,
the IRS ruled that in the two situations presented in the ruling,
which both qualified as F reorganizations within the meaning of
Section 368(a)(1)(F), the newly formed corporations would be
required to obtain new employer identification numbers and that
the existing corporation which became a QSub would retain its
same employer identification number.
6. S Corporation Sale of Assets Structured as F Reorganization Upheld.
In PLR 201115016, the IRS ruled that the contribution of all of an S
corporation’s stock to a new wholly owned corporation (NewCo) in
exchange for all of NewCo’s shares, followed by NewCo’s making a
QSub election, qualifies as an F Reorganization, that NewCo will be
eligible to be treated as an S corporation and that such S election will be
treated not as if it had terminated, but instead had remained in effect.
a. This ruling allowed the owner of the S corporation to use this F
reorganization structure to create a holding company subsidiary
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QSub structure, retaining the portion of the S corporation’s assets
the shareholder wanted to keep in the parent S corporation and
dropping into the QSub the assets the shareholder desired to sell
through a sale of the stock of the now QSub, which will be treated
as an asset sale. In other words, in this ruling the IRS concluded
that F Reorganization treatment applied in a transaction in which
the operations of an S corporation were split up.
X. CONCLUSION
The recent advent of the check-the-box regulations, state law formless conversion statutes
and state “cross-entity” merger statutes make it very easy for a taxpayer (and his advisor)
to change from one form of tax entity to another form of tax entity. As discussed in this
outline, however, the tax consequences of such conversions, and the manner in which
such conversions are effectuated, must be analyzed by the tax practitioner in order to
achieve the best tax results for the taxpayer and to avoid unintended adverse tax
consequences.
